Stryker Corporation Equity Analysis and Valuation

Transcription

1 Stryker Corporation Equity Analysis and Valuation Analysis Group: Hubbal Coffman Katy Craig Jane Holloway Ryan LeBlanc Dustin Synatschk

2 Table of Contents Capital Structure Analysis Executive Credit Risk... Summary Financial Financial Analysis, Statement Forecasting, Forecasting... and Cost of Capital Valuations Financial Statement Analysis... Forecasting Business Income Overview... Statement 90 9 Industry Balance Overview Sheet The Five Statement Forces Model of Cash... Flows Rivalry Cost of Among Capital Existing Estimation... Firms Threat Cost of Equity... New Entrants Threat Cost of Substitute Debt... Products Valuation Bargaining Analysis... Power of Buyers Bargaining Method of Comparables... Power of Suppliers Value Price Creation to Earnings Analysis Trailing Firm Price Competitive to Earnings Advantage Forward... Analysis Formal Price Accounting to Book... Analysis Key Price Accounting Earnings Policies... Growth (P.E.G.) Accounting Price over Flexibility EBITDA Evaluate Price over Accounting Free Cash Strategy Flows Qualitative Enterprise Disclosure Value over... EBITDA Quantitative Intrinsic Valuation Accounting Models... Measures and Disclosure Sales Discounted Manipulation Free Cash Diagnostics Flows Model Expense Residual Manipulation Income Model... Diagnostics Potential Long Run Red Residual Flags... Income Perpetuity Undoing Abnormal Accounting Earnings Distortions Growth (AEG) or Irregularities... Model Financial Discount Analysis, Dividends Forecasting Model Financials, and Appendices... Liquidity Ratio Analysis References Profitability... Ratio Analysis

3 Executive Summary 3

4 Investment Recommendation: Fairly Valued, Hold 4/1/2008 Stryker - NYSE (April 1, 2008) $65.85 Altman's Z - Score 52 Week Range: $ $ Revenue: $6.21 B Market Capitalization: $26.91 B Shares Outstanding: $411.4 M Valuation Estimates Percent Institutional Ownership: 50.90% Actual Price (April 1, 2008) $65.85 Book Value per Share: $14.42 ROE: 19.87% Financial Based Valuations ROA: 12.55% Trailing P/E: $ Forward P/E: $ Cost of Capital Estimate: R^2 Beta Ke P.E.G.: $ Month 17.87% % P/B: $ Month 17.93% % P/EBITDA: $ Year 18.08% % P/FCF: $ Year 18.10% % Enterprise Value/EBITDA $ Year 18.09% % Intrinsic Valuations Published Beta: 1.15 Discount Dividend: $ K d (Before Tax) 5.01 Free Cash Flows: $ K d (After Tax) 3.26 Residual Income: $ WACC BT : 10.88% Long Run Return on Equity: $ Abnormal Earnings Growth: $

5 Industry Analysis Stryker is in the medical instruments and devices industry which is part of the healthcare sector. They specialize in two different areas of the industry including orthopedic implants and MedSurg Equipment. While most of the companies in this industry concentrate in many different areas, Stryker s closest competitors are Zimmer Holdings, Biomet, Smith & Nephew, and Medtronic. Firms in this industry are difficult to evaluate in comparison of each other because they all specialize in different areas of medicine and the fact that there are no two companies that produce identical products. Stryker and its competitors compete on product quality, research and development, innovation, and customer service. Stryker spends $.06 out of every dollar of sales on research and development because this is what the industry demands in order to obtain market share from its competitors. Below is a chart that illustrates the Five Forces Model and how it pertains to the industry. Medical Instruments and Supplies Industry Rivalry Among Existing Firms HIGH Threat of New Entrants Threat of Substitute Products Bargaining Power of Buyers Bargaining Power of Suppliers LOW MODERATE HIGH MODERATE To enter into the medical instruments and devices industry it requires a large amount of capital which keeps the threat of new entrants low. This allows the different firms to grow within the industry without the chance of a new company stealing their market share. The bargaining power of buyers and suppliers makes this industry unique in that the relationships that are created with the customers (medical staff) and suppliers are what drive the industry. A shortage/surplus in supply can dramatically 5

6 shift the industry as far as price and quantity. With such high rivalry among existing firms, the ability to control the price and quality of the products are essential. Accounting Analysis The accounting policies originated by the SEC are known as the GAAP that firms throughout the United States must follow in their business recordings. Accounting numbers are derived from people who are estimating the progress of a company for a certain period of time. When evaluating a company it is vital to address the accuracy of the accounting because the income statement, balance sheet, or statement of cash flows can be easily misconstrued. To determine the accuracy of a firms financial statements, it is necessary to evaluate the transparency and conservativeness that they present through their accounting. Stryker s key accounting policies are recording research and development, capital and operating leases, and defined benefit and pension plans. Their full and untainted disclosure of their research and development expenses is logical compared to the rest of the industry, especially when taking their market position into consideration. Stryker s use of operating leases and lack of long-term debt or capital leases is a clear representation of their financial stability and efficiency. And, the planned out amounts of pension plan benefits and returns show that they are utilizing a fair method of projecting future liabilities. Stryker Corporation does an adequate job disclosing information about all aspects of the company. Their financial reports are very transparent and provide a good understanding of the firm s recent performance and financial position. Management clearly describes what is going on within the industry, their competitive position, and plans for the future. 6

7 Financial Analysis, Forecast Financials, and Cost of Capital Estimation A financial analysis of a company is conducted to determine how a specific firm is performing relative to their competitors. When valuing a firm it is important to look at a series of liquidity, profitability, and capital structure ratios to determine the position of the company. These ratios are evaluated to determine company and industry trends. We then use this knowledge to forecast the financial statements. We then estimated the cost of equity using a regression analysis and the cost of debt by allocating the appropriate weights and rates of the debt for a company. We then plugged these numbers into the weighted average cost of capital formula to get an estimated cost of capital for Stryker. From the liquidity ratios we determined that Stryker was similar to those in their industry. They led the industry in quick asset ratio and inventory turnover. The quick asset ratio for Stryker revealed that they keep a large amount of cash on hand and have more than enough quick assets to meet short term debt obligations. Their high inventory turnover is a result of high sales and them maintaining relatively low inventories. The profitability ratios show us that there are structural differences between Stryker and their competitors. Stryker has lower profit margins than their competitors but they are also in different market segments. The capital structure ratios reveal that Stryker and their competitors rely little on debt financing. This makes it easy to meet debt obligations and keeps the firms away from capital structure risk. For the financial forecasts we took the average growth rate from the past 5 years to forecasts out our income statement, balance sheet, and statement of cash flows over the next 10 years. We also forecasted dividends at a growth of 11 cents per year. We chose this number because that is what they have grown the past two years, and if we took an average of the past 5 years growth it would create an outrageous rate. In estimating the cost of capital for Stryker we took the weighted average of the cost of equity and the cost of debt. We found the cost of equity by running a regression analysis and the cost of debt by taking a weighted average of the interest rate Stryker owes on short term debt and the interest rate they owe on pension plans. With the 7

8 cost of equity and the cost of debt we were then able to find the cost of capital for the entire firm. Valuations Analysis The final step in the equity valuation of a firm is to determine whether or not the firm s current share price is overvalued, undervalued, or fairly valued. Several ways of determining Stryker s equity must be implemented to determine an accurate, intrinsic firm price. We first used the method of comparables as a way to quickly find how Stryker compares to other firms in their industry. We used an observed share price of $65.85 found for the beginning of April 2008 to determine how our different comparable s prices measured up to Stryker s actual share pricing. Price to earnings forward, price to book, price earnings growth, and enterprise value to EBITDA all found the firm to be fairly valued at prices of $57.85, $65.63, $27.50, $ The price to earnings trailing and price to free cash flows found the firm to be undervalued with prices of $83.61 and $ The only method that found the firm to be slightly overvalued was the price to EBITDA model with a price of $ Our final decision as to how accurately Stryker s current stock price is valued was based on the intrinsic valuation models. Although all five models are highly informative, less emphasis is placed on the findings of discounted dividends and free cash flows model as both are highly sensitive to changes in the growth rate. Discounted dividends found Stryker s intrinsic price to be $21.38, meaning their current price is overvalued. Free Cash flows found Stryker s intrinsic price to be $94.37, meaning Stryker s current price is overvalued. Residual income found Stryker to be slightly overvalued and abnormal earnings growth both found Stryker s current price to be fairly valued with intrinsic prices of $41.99 and $57.03, respectively. Long run return on equity found the intrinsic price to be $67.54, giving the assessment that Stryker is fairly. Both the abnormal earnings growth as well as the residual income model can be linked together using the annual change in residual income. As these models are less sensitive to change, more importance is placed on their findings. 8

9 After evaluating the intrinsic model valuations, we found Stryker s share price as of April 1, 2008 to be fairly valued. Company and Industry Analysis Company Overview Stryker was founded in 1941, in Kalamazoo, Michigan, by an orthopedic surgeon named Dr. Homer Stryker. Dr. Stryker felt that certain medical products were not meeting his patients needs so he developed new ones. He then started the Stryker Corporation to produce them. His goal was to help patients lead healthier lives through products and services that make surgery and recovery simpler, faster, and more effective. Today, Stryker Corp. has grown to over 15,000 employees worldwide and is a global leader in medical technology. Stryker more specifically competes in the medical instruments and supplies industry. They divide their operations into two segments: Orthopedic implants and MedSurg equipment. The Orthopedic Implants segment sells all forms of orthopedic reconstructive, trauma, spinal, and craniomaxillofacial implant systems. The MedSurg Equipment segment offers surgical equipment, surgical navigation systems, and patient handling and emergency medical equipment. Stryker Corp. also provides physical, occupational, and speech therapy services to patients recovering from orthopedic or neurological illness and injury. Stryker primarily competes in this industry against companies such as Biomet, Inc., Smith & Nephew, and Zimmer Holdings Inc. Stryker Corp. currently has a market capitalization of 27.5 billion dollars which leads the industry. From a financial standpoint, Stryker has done very well both in the United States as well as overseas. Stryker s sales have substantially increased in all of their segments each year for the past five years. Overall, their total sales have increased by 79.5% in 5 years as shown in the chart below. Stryker has also managed to increase its total assets as well as shareholders equity for each year over the past 5 years. They have almost no long term debt, yet appear to be growing in every 9

10 category. Their stock prices have risen steadily since they started trading stock in February of Business Segment Sales: Orthopedic Implants 3, , , , ,704.8 MedSurg Equipment 2, , , , ,105.3 Other Total Sales 5, , , , ,011.6 Domestic/International Sales Domestic 3, , , ,973.7 International 1, , , ,037.9 Total Net Sales 5, , , , , The graph above shows the sales of Stryker Corporations different business segments for the years 2002 to Below is a chart showing the stock performance of Stryker from Jan. 30, 2003-Jan. 30,

11 Industry Overview Medical instruments and supplies is a highly competitive industry. Stryker faces three main competitors: Smith & Nephew (SNN), Zimmer Holdings Inc. (ZMH), and Biomet. There are around 12,000 different competitors in this market ( That being said, the industry is highly competitive. Smaller firms compete based on specialization of certain products whereas larger companies compete on innovation and economies of scale. Large companies in this industry spend vast amounts of money on research and development and then patent those innovative ideas. The medical supplies and devices industry is one that can be extremely profitable if approached in the right way. However, there are many factors which have caused problems for all the top firms within the industry. These include but are not limited to: high fixed costs, problems with product differentiation, high economies of scale, and high concentration. However, there is an ongoing increase in demand which is expected to continue well into This increase will be caused by a large demographic change in the U.S. By 2050, according to Census, it is estimated that 20.7 percent of U.S. citizens, or approximately 87 million people, will fit into the demographic category of elderly ( The aggressiveness of the industry can be seen by a lawsuit filed on September 27, The five major competitors in the hip and knee replacement sector, Zimmer, Inc., Depuy Orthopedics, Inc., Biomet, Inc., Smith & Nephew, Inc., and Stryker, were all accused of using financial inducements as incentives for surgeons to use their products. The companies were then required to execute all modifications required to the way they conducted their business. This included 18 months of federal monitoring ( 11

12 Five Forces Model The Five Forces Model is a unique tool designed to evaluate, analyze, and assess the structure and profitability of a company. It provides a way of targeting the most important aspects of competition and bargaining power with its suppliers and customers. The degree of actual and potential competition can be subdivided into three categories: rivalry among existing firms, threat of new entrants, and threat of substitute products. Another part of differentiating an industry is looking at its bargaining power in input and output markets. This indicates how well an industry maintains their bargaining power with their buyers and suppliers as well as identifies the profitability and potential of a company. These key factors allow any analyst to evaluate a firm and establish how profitable the industry is. Medical Instruments and Supplies Industry Rivalry Among Existing Firms Threat of New Entrants Threat of Substitute Products Bargaining Power of Buyers Bargaining Power of Suppliers HIGH LOW MODERATE HIGH MODERATE Below the medical instruments and supplies industry will be discussed in detail pertaining to these guidelines mentioned above. Rivalry Among Existing Firms The profitability of a company greatly depends on the rivalry among existing firms because it allows investors to see how much activity there is throughout the industry and how it relates to each individual firm. In the medical instruments and supplies industry, companies compete on how they differentiate themselves from their competitors in the terms of patents and research and development. In the US, the medical instruments and supplies [industry] includes 12,000 companies with combined annual revenue of $50 billion ( The top 50 companies in the 12

13 industry experience high rivalry among existing firms because the industry s growth is directly related to the inventions and innovations that a company makes to their product lines. There is a direct correlation between the amount of money a company spends on research and development and how high it ranks within the medical instruments and devices industry. Large companies are able to compete based on economies of scale and ongoing research and development whereas smaller companies compete based on field specialty. For those wishing to join the industry, large fixed costs must first be taken into consideration as well as lack of any reputation among buyers. Also, new entrants must consider the large economies of scale, first mover advantage. Companies in this industry choose to specialize in one to three areas of the healthcare sector and medical instruments and supplies industry in order to obtain the highest percentage of market share. This industry differentiates companies by their ability to make superior products which in return determines profitability of a company ( Industry Growth According to the chart below, the medical instruments and supplies industry is forecasted to grow at an annual compounded rate of 6.1 percent between 2007 and 2012 ( ( /free-co-competition.xhtml) The growth of the industry is going to be related to the number of people needing orthopedic and MedSurg supplies. With an upcoming increase in the number of Americans over the age of 65, the growth of the industry is bound to occur in all 13

14 areas of healthcare. The companies in this industry are preparing for this by increasing their research and development to produce state of the art products for doctors and hospitals to use. The medical instruments and supplies industry is growing at a constant rate from 2003 to 2008 of 50 percent while the healthcare sector s growth is only 33 percent. The graph below shows how the industry and sector have grown in the last 6 years in reference to the S&P 500 Average. --Medical Instruments and Supplies --Healthcare Sector --S&P 500 Average ( port) Industry Concentration To determine the concentration in an industry, it is necessary to consider the number of firms in the industry and how the market share is distributed. With the fifty largest companies in the industry holding 60 percent of the market share, the medical instruments and supplies is a highly concentrated industry ( The ability to specialize in many different areas is a way that small companies can escape 14

15 the high pressures that the larger companies pose due to high concentration. Small companies are forced to compete on price which makes it very difficult for them to invest as much money in their research and development department. This gives the larger firms a huge advantage because they are able to devote more money to improving the quality of their products while inventing new medical instruments and supplies for their buyers. The chart below illustrates the market share of the medical instruments and supplies industry from 2002 to Stryker has been the larger portion of the market share for the past five years which indicates how the larger companies have control of the industry. (Sales from 10Ks of each company-syk, ZMH, BMT, SNN) The concentration is what determines if the industry competes on differentiation or cost structure based upon the market segment and competition. The medical instruments and supplies industry allows for innovation through research and development instead of focusing on cost structure. 15

16 Differentiation For companies to differentiate themselves in this industry, they must compete effectively on innovation, reliability, service and reputation. That is why it is so important for companies to spend money on research and development. With the healthcare industry moving at such a fast pace, companies must keep innovating their products to keep from being left behind in this fast-paced environment. In the medical instruments and supplies industry, a key component of sustaining sales is the relationships that companies form with their buyers. Doctors and hospitals trust that the company is continuing innovation and providing them with the best possible products at the lowest possible prices. This reliability is necessary in this industry in order to keep producing top of the line products. Service is another aspect that differentiates a company from the industry. In the buyer/producer relationships, service is what is going to make a company thrive and stand out among the others. The ability to create new products in a timely order, incorporate fast shipping, enable great communication, and respond to feedback is what buyers look for in customer service. This is what gives the company a competitive edge. Reputation is the accumulation of the previous parts, innovation, reliability, and service. This is acquired over many years which makes it harder for smaller and newer companies to increase market share in this industry. Switching Costs Switching costs in relation to Rivalry among Existing Firms describes a company s ability to change the industry that they are currently in to another industry in hopes of generating more revenue and expanding the company. This is a very relevant issue in the healthcare sector because companies change their focus and industry quite a bit depending on their recent innovations and desires to gain market share. In this industry, there are high switching costs associated with changing industries because it is difficult for a firm to do something else with the same resources they have been using for years. With many companies shifting their product lines to different industries, it allows for switching costs to be comparatively low. 16

17 Learning Economies of Scale Learning economies of scale is prevalent in the medical instruments and supplies industry because there is such an advantage to knowledge in the form of research and development. All firms in technology based industries have a large economies of scale. This is determined by the immense difficulty that new entrants face and the impact that large companies have on the market share. In this industry, market share is dominated by the top 50 companies at 60 percent ( Large companies thrive in the medical instruments and supplies industry because of the buying power they have created with doctors and hospitals and the amount of money they are able to devote to research and development. The graph below demonstrates how much the companies in the industry spend on research and development in correlation to their sales. Stryker Zimmer Biomet Smith & Nephew (Research and Development per sales from 10Ks of SYK, ZMH, BMT, SNN) 17

18 The graph above demonstrates how the economies of scale for the medical instruments and devices industry focuses on research and development. The larger companies make it hard for smaller companies to increase market share because of the amount that is spent on research. This proves the industry has a large economies of scale. Fixed-Variable Costs The cost of an industry is distributed into fixed and variable cost. This is very important in this industry especially when it comes to the ability to save money on fixed cost and spend money on research and development. Fixed costs are what keep smaller companies from excelling in this industry because it is very difficult for them to compete on the same level as the larger companies. The large economies of scale are also a factor in these cost comparisons because this pertains to smaller companies entering the industry. Excess Capacity Excess capacity is a major factor when it comes to price competition in the industry because it entices companies to sell their remaining inventory by cutting prices. This is an effect of the levels of supply and demand. In the medical instruments and supplies industry, there are fewer large companies, yet they make up most of the market share. This illustrates that the industry is reaching excess capacity and the demand levels are increasing. According to the census, the growth of people over the age of 65 from the baby boomer generation, increases the need for medical supplies at a constant growing rate allowing for all of the companies to experience an increase in sales. In most industries, this would lead to an increase in price because the demand for these products is increasing. Yet, due to FDA regulations this industry is highly monitored to insure that there is a fair price for consumers. Though all firms in this industry will experience an increase in sales, smaller companies will continue to have lower market share due to excess capacity. 18

19 Exit Barriers Exit barriers are what keep a firm from leaving an industry without a certain level of difficulty. There are very high costs associated with leaving the medical instruments and supplies industry especially with expensive machinery used to develop products and high FDA regulations. To manufacture orthopedic supplies and MedSurg equipment requires very expensive equipment that can require long-term loans to pay off. Most of these machines are only used for certain uses and can t be transferred to other industries. FDA regulations including patents are expensive to achieve with the research and development expenses attached to it. Since governments spend so much on health care, their policies have an outsize impact on sales of drugs, devices and treatments ( The FDA controls how substantial the exit barriers are and what expenses are attached to them. These are the main reason that there are high exit barriers in this industry. Conclusion The rivalry among existing firms in this industry is high. There is very strong competition in the top companies in the industry for market share. Even the small companies are in competition with the other smaller companies. Market share can change based on a new invention or patent that was developed by a direct competitor in the industry. Due to a stable industry growth, it is very difficult for new entrants to enter the industry because of the expensive research and development costs. The medical devices and instruments industry experiences a high concentration due to high innovation and differentiation levels. Switching costs are low because an innovation of one part of the medical industry can bleed over to other industries. This would make a company consider expanding into another industry to keep the innovation within the company. Economies of scale are large due to the amount of money spent each year on research and development. With high excess capacity, the demand for the industry is increasing creating more rivalry among firms. High exit barriers keep companies from changing industries often which intensifies rivalry among firms. With all of these 19

20 factors in mind, the medical devices and instruments industry has high rivalry among existing firms which leads to high competition and profitability. Threat of New Entrants The healthcare industry is one that has the potential to create excessive amounts of wealth for companies that are able to enter the market. However, potential new firms must first consider the likely barriers to their entrance. These include: large economies of scale, first mover advantages, access to channels of distribution and relationships, and legal barriers. Due to the vast amounts of start-up cost involved in opening a medical supplies company, those who have long since infiltrated the industry have a competitive advantage over those who have yet to enter the market. Economies of Scale Total Assets Stryker 7,354,000 5,873,800 4,992,500 4,083,800 3,159,100 Zimmer 6,367,200 5,974,400 5,721,900 5,695,500 5,156,000 Holdings Smith & 4,276,000 3,231,000 3,438,880 2,984,020 2,552,690 Nephew Biomet 2,457,861 1,720,194 1,568,844 1,451,669 1,289,742 * Statistics provided by Google Finance and Biomet s 10K The chart emphasizes the size of the assets for Stryker and Stryker s top three competitors in the medical instruments and supplies industry. Large economies of scale make it very difficult to penetrate this industry. Those who are considering entering the market must take this into consideration. The cost of start-up is high because of 20

21 increased research and development pricing. Aside from the typical start-up cost, building, materials, et cetera, companies in the healthcare field must also be willing to spend huge sums of cash on doctors who can then develop new devices for their consumers which are then patented. First Mover Advantage Firms who entered the market early on have a competitive advantage over those who have not been a part of the market for some time. Relationships with suppliers are agreed upon first as well as with the customers who will then market the company s product. However, firms can create their own competitive advantage by creating and patenting a new product. This gives ample opportunity for any company thinking of entering the market, no matter the size. Distribution Finding and creating terms of agreement between their distributors and suppliers within this industry is imperative to company growth. Existing firms have the competitive advantage over new firms as they have already created and maintained relations with both their distributors and suppliers. Gaining distributors in this market could prove futile to those who do not already have contracts set up. It was previously mentioned that the top five companies within the medical supplies and devices industry did engage in what can be termed as illegal activity of paying kickbacks to their doctors and consultants through financial payments ( 85-million/). Due to this lawsuit among the top companies in the industry, they are required by law to publicly disclose all information regarding the monies distributed to surgeons and doctors who then endorse their products ( This is an example of how competitive this market is when finding and keeping their main distribution sources. 21

22 Relationships Firms must also have a means of distributing and housing their products. Adequate warehousing for inventory and excess inventory, labor capital, supply chains, and a means of transportation for their products are all necessary. For example, Zimmer Holdings has more than 100 manufacturing, distribution and warehousing facilities worldwide (Zimmer Holdings 10-k). Out of Stryker Corporations 16,026 employees worldwide as of December 31, 2007, 6,643 of those were being used in the manufacturing, warehousing and distribution operations (Stryker s 10-k). Substantial spending is a must for all companies wishing to pierce the market. In order to save on excess spending, sufficient time must be spent on developing a supply chain that is both efficient and realistic to the firms profit goals as well as to what can be spent on expenses. If maximum distribution efficiency is obtained, the company will then have maximum control of their inventory, higher levels of customer satisfaction, and be able to meet and sustain higher quality levels of their products as a whole ( In order to cut back on cost, firms in the market must find suppliers who are willing to discount their materials. Cost is a major concern. Those who plan on maintaining market share must find several suppliers and then maintain good relations with said suppliers. Legal Barriers Legal barriers must also be addressed by firms interested in entering the market. Viable companies must address these barriers and be aware of the repercussions they could face if the firm chooses to disregard them. The healthcare sector is regulated by the Department of Justice and U.S. Department of Health and Human Services, the Food and Drug Administration (FDA), Centers for Medicare and Medicaid (CMS), Health Insurance Portability and Accountability Act (HIPAA), Joint Commission on Accreditation of Healthcare Organizations (JCAHO), and the National Committee for Quality Assurance (NCQA). Those entering the industry must also pay special attentions to the patents of other firms. 22

23 Conclusion Firms that plan on being introduced into the medical supplies and devices division face many factors which could derail their successful breach of the market. These potential threats include economies of scale, first mover advantages, distribution and relationships, and legal barriers. In order to be flourishing in this market, new firms must find a way to differentiate themselves from their competitors by selling exceptional products while also finding ways to cut back on cost through good supplier relations. Threat of Substitute Products Introduction Within this industry, threat of substitute products is moderate. There is simply no substitute for receiving a prosthetic limb or hip implant. These are specialty items which, though the material that they are produced with may differ from company to company based on patent restrictions, are virtually the same product. The company must then compete on the pricing and reliability of their products. Relative Price and Performance The medical instruments and supplies industry is built on the basis of function and performance first, price second. Often times this idea is misconstrued due to the rising cost of health care. There is a split in the market now between specialty products and commodities. Specialty products are products or services that either require a certain, special knowledge or resource for its use, or provide a unique service not found commonly. Special products can include implants, methods for surgeries, tools for certain special procedures (such as neurosurgery or arthroscopy), software for analyzing injuries and tracking progress, and imaging systems. Also specialty products bear a higher level of complexity or development, which means these products tend to be more expensive 23

24 because of the expense that went into these products during the research and development stages. According to Wall Street Journal s Race Is on for the Next Blood Thinner, Doctors have long wanted an alternative to warfarin. The drug requires patients to have frequent blood-test monitoring, and it can produce serious side effects if it reacts adversely to other drugs a patient takes, a common occurrence, or even to a change in diet. As a result, there is now a race among big-name companies for the most innovative new blood thinner, which is almost, if not entirely, research and development oriented. The most successful company will get to partake in the predicted 10-billion dollar market for blood thinners. Specialty products also tend to be protected by some form of government regulation, like a trademark or a patent. For example, Baxter has the patented VIAFLEX flexible container systems and AVIVA containers. They offer a special service to their customers and they have kept it from being copied by any possible competitors in the market. All products in the medical instruments and supplies industry must be approved by the FDA before they can be implemented into use. Some products, such as Stryker s OP-1 bone therapy treatment, can even be given approval for a Humanitarian Device Exemption (HDE) from the FDA. The FDA defines an HDE as a product intended to benefit patients by treating or diagnosing a disease or condition that affects fewer than 4,000 individuals per year in the United States. Both FDA approval and government patents/trademarks serve as protection for the big companies that make these special products. This keeps the court cases you hear about in the news shorter and less expensive for the medical instruments and supplies companies. Because of the nature of specialty products, it is the performance factor that outweighs the price factor in specialty products. On the other side of the market, commodities are common products used by a majority of either people in the industry or affiliated with it (surgeons, nurses, etc.). The key separation between the commodities and the specialty products in the medical instruments and supplies industry is that much more technology and research is put into specialty products. The uses of specialty products tend to be much more difficult. 24

25 Wikipedia defines a commodity as being anything for which there is demand, but which is supplied without qualitative differentiation across a given market. Medical technology equipment commodities have a very broad spectrum of products ranging from medical instruments, many are disposable, to dental and veterinary instruments. Commodities can also range from being long-term or shortterm. Long-term commodities can be things like office furniture, x-ray machines, surgery tables or even monitors. Short-term commodities can be things such as clothing, disposable surgery kits, drugs and biologicals, dressings, lab equipment, and even cleaning materials. The commodities market must also be innovative. For example, Vital Signs, Inc. produced a pressure infuser with a clear window in order to read fluid levels better. Things like that, simple innovations that do not cost much, are the qualities that make a commodity product more desirable. However, there are higher levels of competition between companies on the commodity level. Price then becomes the most important deciding factor with buyers. Many commodities are based on this analysis. Does the cost exceed the benefit? That is not to say that there is not room for innovation in commodities, like designing handles better or making the blades a certain shape or the tube longer, skinnier, or more flexible, but not so much room to improve that it drives the price up so high that the cost outweighs the benefit. In the end all that matters is that the product will do the job properly and efficiently and is of low cost to the consumer. Buyer s Willingness to Switch Many companies make products that are used for the same purpose. The key to the retention of medical instruments and supplies customers has a lot to do with the buyer s willingness to switch. Many strategies can be used to retain customers, like marketing, customer service, internet relations, quality management, or the expertise in a certain field. One surgeon may prefer a certain brand of products to another simply because he has been with the company for several years and trusts their products and the relationship. 25

26 Unless the price of another product lowers substantially or the benefits of using another product make it more necessary to fulfill a previous need, that customer will not switch. Also, many products are being made that do not require the customer to use as much of it, or use it as often. This has been an influence for many buyers to reduce their supply of products. Surgeons are required to do their job exactly right every time. Trusting themselves as well as the products they are using to operate on their patients is crucial. For example, Baxter has been around for 75 years. The longevity of the company itself as well as their consistently high quality products has helped propel them to the top of the industry. Another industry leader, Alcon, has been in the eye care market since They have accumulated large quantities of proprietary knowledge and skill at what they do which makes them a more technologically advanced and trustworthy company. Buyers will stay with a company for one of two reasons: either they are the only one that makes the product they need or the company makes the buying process easier. Companies make the buying process easier by offering great customer service, giving benefits to long-term or bulk customers, or by helping that buyer personally. An example of this would be helping the buyer to install the x-ray machine they bought, teaching them how to use it if it is different from the last model they purchased, and having a customer service hotline. How the buyer perceives the benefit is crucial, and going the extra step is a way that many companies retain customers. A hospital can receive benefits such as a discount on buying scalpels or medical kits in bulk, or by using software on a per-use basis (as opposed to buying the program which can be very expensive), or by receiving a discount for being a returning customer with the company for more than five years. A personal benefit could be the ease of ordering, if they offer online ordering or have automatic inventory systems that re-order when the buyer is out of certain supplies. In the end, buyers will always need their product. If they can get it with a greater benefit, they will switch companies. 26

27 Conclusion New entrants to the market should consider the aforementioned things before entering into the market. If they cannot provide the service as good if not better than their competitors, they will chance having a failing company. In order to be successful, companies must keep in mind that their financial prosperity is not only determined by how they make their products, but also how they distribute and market their products. Bargaining Power of Buyers Whether or not the buyers have bargaining power influences how the various companies conduct their business. If the buyer has large amounts of control over the company, then the company will be forced to keep their prices low. However, if the buyer has little control over the company, the company s strategy can differ based on their own personal preferences. The healthcare sector has been on a continual rise for years and it is expected that the market will continue to grow well into To date, the top 50 firms own 60% of the market share ( ID 69--/free-ind-fr-profile-basic.xhtml). With that in mind, it is safe to assume that these leading companies are able to price set based on their large economies of scale. It is also important that companies specializing in or developing unheard of products have what can be termed as a monopoly over their specific products industry. Price Sensitivity Price sensitivity gives an indication as to what the individual is willing to pay for a particular product. If a consumer is highly sensitive to changing prices, they will simply refuse to buy the product in consideration. However, if the consumer is insensitive to the price changes, they will continue to buy regardless of an increase in price. As many companies product lines are necessary for the continued well-being of their ultimate consumers and can be assumed to have relatively insensitive demand. Choice of product within the industry ultimately comes down to how reliable and innovative the product offered truly is. Those that lack good standing within the medical 27

28 community already have problems endorsing and outperforming their predecessors. If companies already established in their field continue to endorse their products with their relatively low prices, as compared to that of their competitors, it can be assumed that their company will continue to flourish, all other factors being equal. Relative Bargaining Power The bargaining power of the consumer can be determined by whether or not the consumers outnumber the producers, the volume each consumer will purchase, and the number of products deemed as alternatives to products already offered within the industry. As each consumer can decide to endorse only one company s products, it is imperative to producers that they remain in good standing with the consumer who chose them. The number of products they purchase will ultimately be determined relative to their patient size. If a company s product underperforms as deemed by the medical community, then their business could then be shunned by the doctor who previously endorsed their products. The market could be deemed to be volatile based on these assumptions. The consumer then has a higher than average bargaining power over the medical instruments and supplies industry. Conclusion The bargaining power of the consumers depends upon their size as a whole and how sensitive they are to the fluctuations of prices. If a company truly wishes to gain a fair portion of the market share, they will have to accommodate the aforementioned and create a plan of action around their consumer s wants and needs. Otherwise, the company could face bankruptcy very early on. 28

29 Bargaining Power of Suppliers Bargaining power of suppliers is important in all industries because the amount of power suppliers have provides structure and control in the pricing of an industry. Firms in this industry purchase most if not all of their raw materials from multiple suppliers around the country. Companies choose to outsource their materials to ensure high quality, reliability, and cost effectiveness. They are able to do this by driving up the costs for firms causing them to raise prices. Suppliers have the highest bargaining power when there are few companies for buyers to choose from and few substitutes are available to their customers. In this situation, suppliers are able to make companies pay almost whatever they desire for their products. On the other hand, when there are many firms present and a variety of substitutes available, suppliers have low bargaining power. Firms can force these suppliers to sell certain quantities of product at lower prices or face the risk of losing their business. Relative Bargaining Power In the medical instruments and supplies industry the power of suppliers is moderate. Most firms in this industry purchase a very small percentage of finished products from outside suppliers. Firms mainly buy different raw materials from suppliers such as stainless steel, aluminum, cobalt chrome and titanium alloys. They then use them to manufacture different patent specialty products. Although many firms in this industry use single sources for certain materials and services, alternative sources are available if needed. There are no significant difficulties obtaining materials needed to meet production schedules. This describes the relationship firms in this industry have with their suppliers. This relationship must be maintained or else both the supplier and the buyer will suffer. The bargaining power of suppliers is not considered high in this industry because most firms are very substantial, and these firms buy large enough quantities for suppliers to be in need of their business. That said, as there are not a great number of suppliers readily available, the suppliers do have some bargaining power. 29

30 Price Sensitivity The price sensitivity of the suppliers to the various firms in the medical instruments and supplies industry determines how buyers react to price increases and decreases in the market. Buyers are more price sensitive when there are few switching costs and the product is undifferentiated (Palepu, Healy, and Bernard). Buyers in this industry are moderately price sensitive. The products they buy are somewhat undifferentiated because these firms by the same types of raw materials. For instance, firms purchase metals such as stainless steel, aluminum, cobalt chrome and titanium alloys. In the medical instruments industry, buyers are also more likely to expend the resources necessary to shop for lower cost alternatives, because the products these firms are buying represents a large fraction of their cost. If the firm who sells the materials to the company has a sudden increase in price, it is likely that the company will then search for another firm to buy their materials from which offers more competitive rates. Quality plays an important role on the price that firms in this industry are willing to pay for the raw materials they buy. Better quality matched with lower prices is becoming the standard set by the market. Buyers require high quality products. Conclusion The bargaining power of suppliers is moderate in this industry because, although there are few suppliers, the buyers buy in mass quantities giving them a good bargaining position with the suppliers. Many firms also use only one supplier and it is imperative that the buyers and their suppliers remain on good terms. In order for this to be accomplished, suppliers must continue to sell high quality products at a competitive price and communicate well with the buyers. 30

31 Strategies for Creating a Value Chain The medical instruments and supplies industry of the healthcare sector is highly concentrated and extremely competitive. In order for a firm to be viable within the industry, they must develop several different strategies to give them a competitive edge. By achieving a competitive advantage in the market, firms create value within themselves. To achieve superior performance in the healthcare sector, firms must develop ways to differentiate their products or compete with a cost leadership strategy. Although most firms in this industry create a competitive advantage by differentiating they must also pay attention to product cost. Differentiation One of the main ways firms create value within the industry is to differentiate themselves from others in the market. Differentiation, according to the Palepu and Healy, is supplying a unique product or service at a cost lower than the price premium customers will pay. It is very important in the medical instruments and supplies industry that each company differentiates themselves from their competitors. To differentiate themselves most firms strive for better product quality, superior product variety, and innovation. Superior Product Quality Creating a product of superior quality is a must for any company wishing to remain a part of the ever-growing healthcare industry. It is imperative for companies to make and distribute products of the highest quality as these products impact the lives of the people who receive them. For example, Stryker was able to excel in the endoscopy industry because of the superior quality in cameras and intuitive user controls for the Stryker 3-Chip HD Cameras. This allows for surgical teams to improve visibility and effectiveness during endoscopic procedures (Stryker 10-K 2007). Every firm must strive to have almost no error in their manufactured products. Product lines must also meet and ascribe to FDA regulations and patent restrictions placed upon each 31

32 firm individually. The FDA requires extensive clinical testing which focus on the safety and effectiveness of the product. Superior Customer Service The medical instruments and supplies industry differs in how they offer customer service compared to other industries. While some industries in other markets offer customer service with the intent of making a sale, companies in the medical field offer customer service that is provided in the form of therapy and making products that best suit customers. Medical instruments and supplies companies are being monitored to hold up to a "corporate integrity agreement" to protect patients from physician malpractice ( For example, Zimmer Holdings uses their service expertise to excel in the marketing and sales department. Their sales team has developed professional relationships with potential and existing customers from their detailed knowledge of their products and instruments (Zimmer Holdings 10-K 2007). Firms in this industry work really hard to provide a variety of products and services that will please consumers. Innovation For both the large and small companies in this industry, innovation is of the utmost importance. Spending a substantial amount of overall profits on research and development each year is necessary. Creating an innovative product and then patenting it before your competitors have the chance gives firms a competitive edge necessary to remain in the aggressive market. Innovations and new developments can change the lives of patients forever. For example, new technology from research and development offers the possibility that an amputee may one day be able to feel with an artificial limb as although it was his own ( Patents and trademarks are also of great value to firms that possess them. Companies in this industry have an enormous amount of patents to protect their research and development costs. For example, Stryker, Smith and Nephew, and 32

33 Zimmer Holdings have 2,150, 3,200, 4,000 patents respectively on their products (Stryker, Smith and Nephew, and Zimmer Holdings 10-K). Oftentimes, larger firms will purchase smaller companies that have developed and patented promising ideas ( 69--/free-ind-fr-profilebasic.xhtml). Conclusion In order for firms to have a competitive advantage within the healthcare sector, they must pay particular attention to ways in which they can differentiate themselves from others in the market. Superior product quality, great customer service, innovation, and an aggressive sales and marketing team can give a firm the upper hand necessary to remain feasible in the industry. To disregard these important factors, a firm can lead to a downturn in their competitive advantage in the industry and overall decrease their value. Cost Leadership Although more importance is placed on differentiation within the medical supplies and devices industry, some firms do try to compete using a cost leadership strategy. In the recent years, there has been an increased cost of medical care. Since 1997, overall hospital bills have risen 89 percent and general rehabilitation costs have increased 77 percent ( These kinds of statistics are challenging some firms in the industry to look to a more cost effective strategy in order to provide medical supplies and devices to all kinds of people with all kinds of income. If a firm is able to achieve a working cost leadership strategy, then that firm can then make a higher profit per unit while still charging the same price as their competitors. However, using a cost leadership strategy as compared to a differentiations strategy is risky one because there are few opportunities for companies to cut cost or provide products that are cheaply made. Firms can still compete using this strategy by placing the majority of their emphasis on economies or scale and 33

34 making sure they have lower input costs. They also must focus on having an efficient production line. Economies of Scale In order to provide a low cost product to their consumers, the company in question must drive down the prices provided to them by their suppliers. Firms in this industry are able to do this because they buy large quantities of raw materials from their suppliers and then manufacture the product themselves. In doing so, they lower their input cost. As previously mentioned, lowering input cost leads to higher profit yields without having to raise the price of the product being offered. Firms must do this as their prices are often regulated by government agencies. Without lowering their input cost, they stand to make little profit. Efficient Production Line An efficient production line is vital to the welfare of the company. Inefficient production lines lead to wasted materials and a potentially higher cost for the company. To thwart these higher costs, companies can engage in precision machining, metal fabrications and assembly operations. Conclusion A cost leadership strategy is often not what firms in this industry choose to focus on. However, if properly implemented, the firm that chooses to implement this strategy stands to gain profits that their competitors who engage solely in differentiation will not earn. 34

35 Firm Competitive Advantage Analysis Stryker is one of the world's leading medical technology companies with one of the most widely based range of products in orthopedics. Stryker is also a significant presence in other medical fields. Their products improve medical professionals, as well as patient s lives in 120 countries worldwide. The company s unmatchable growth has come from their innovative products, customer service, reliability and great reputation. These factors have had Stryker named one of Americas most admired companies by Fortune. Historical Innovations Stryker was first formed when Dr. Homer Stryker, an orthopedic surgeon from Kalamazoo, Michigan, realized that certain medical products were not meeting his patients needs. Dr. Stryker then began to make new products that did fit his patients needs. These products started to become more and more popular. Therefore he decided to start the company in There was a high risk involved with making new products to be placed in the human body. All it would have taken is one faulty product and Dr. Stryker s reputation and career would have been ruined. Instead the products worked better than other products available on the market. The high risk turned into a high return for Dr. Stryker and gave him a competitive advantage in the industry. Dr. Stryker 35

36 Current Innovations Since there is a direct relationship between the amounts of money a company spends on research and development and the rank of medical instruments and devices, there should be no surprise that Stryker is ranking among the top three medical products and equipment companies for three years straight ( The company s current innovations specialize in orthopedic implants and medical surgery equipment. About twenty years ago Stryker joined forces with Curis inc. and started a long term investment in the study of bone growth called OP-1. This product is a natural protein that the human body makes to induce bone formation. Stryker is the first company to enter OP-1 into clinical studies. Studies have been performed in two clinical sections, fractures of long bones and spine fusions. Stryker has received approval for a Humanitarian Device Exemption (HDE) from the FDA. That is the approval to use the OP-1 implant in the United States as an alternative to auto graft in long bone nonunions. As of December 31, 2006, Stryker had more than 800 hospital Institutional Review Board (IRB) approvals for OP-1 Implant in patients in the United States under this HDE ( Most of Stryker s implants are designed for minimally invasive surgery (MIS) procedures. This is a type of surgery that uses a smaller incision and reduces soft tissue damage and pain. Future Innovations Demand for OP-1 Implant and OP-1 Putty continued to increase each quarter. Stryker continues to further the development of OP-1 as an alternative to bone crest graft for patients requiring a spinal fusion. Spinal fusion is used to strengthen the spine for the patients. Stryker is also interested in researching the cartilage regeneration properties of OP-1 and has successfully completed studies showing that OP-1 can stimulate new cartilage formation and increase disc height in animal models. Stryker also continues to research and develop new technology for the surgery process. This technology ranges from saws doctors use to cut during an operation to Computerassisted technology that does the cutting for the doctors. All products are made with 36

37 the intent of offering customers cost and time savings by reducing the number of steps in the surgical process as well as the accuracy ( Differentiation Stryker s goal is to gain the largest portion of the market share in this industry is to find ways to separate themselves from their competitors. They focus on differentiation as opposed to cost leadership as pricings within this industry are already structured. Finding loopholes to agreements already set in place by firms is close to impossible. Instead, they focus their resources on developing superior customer service, spending adequate funding on research and development and then creating a variety of high quality products. Customer Service Stryker Corporation began in 1941 with the intent to produce medical products which would meet Dr. Homer Stryker s patients medical needs. The company was started with the customer s needs in mind and continues to accomplish this goal by helping patients lead healthier and more active lives through their products and innovations. In order for Stryker to continue to compete effectively they must provide quality customer service and maintain a good reputation. Some ways Stryker maintains quality customer service is by keeping close working relationships with physicians and medical personnel in hospitals and universities who assist in product research and development as stated in Stryker s k report. Stryker also provides physical, occupational and speech therapy services to patients through an outpatient program. This is merely one example of the continual care Stryker provides to the ultimate consumer, or the patients who are recovering from orthopedic or neurological illness. Stryker has been able to build and maintain a longstanding reputation as the leading provider of medical devices through their good business practices and customer service. Stryker is well known and their good reputation allows them to lead the industry with the highest market cap, net income, and overall revenue ( 37

38 Innovation The main way Stryker gains a competitive advantage over its competition is through innovation. Their survival will depend on how well they develop new products and make improvements to existing ones. Thus, they spend millions of dollars on research and development each year to make sure they stay on top of the industry. Stryker does a very good job making new, unique, creative products and that enables them to get where they are today. It is also important that Stryker protect their ideas from competition through their patents and trademarks. Although, Stryker doesn t consider the patent a major factor in its overall competitive success, they do try to obtain them whenever possible. The Company currently owns approximately 820 United States patents and 1,330 international patents which is stated in Stryker s k report. Superior Product Quality and Variety Another way Stryker gains a competitive advantage is by providing a variety of top quality products. Stryker has divided their various product offerings into two main categories: MedSurg Equipment and Orthopedic Implants. These two divisions are divided up in order to gain the greatest share of the market by taking on both the specialty and commodity side of the market. Stryker s Orthopedic Implant Division is where Stryker produces their specialty items in the market. Their specialty products compete in a smaller niche within the medical technology market. Among these systems and specialty implants are several differentiated versions of Hip Implant Systems, Knee Replacement Systems, Trauma Implant Systems, Craniomaxillofacial Implant Systems, Spinal Implant Systems, and then there s OP-1 bone therapy and bone cement. Stryker s Medsurg Equipment focuses on the commodity side of Stryker s sales. This segment creates heavy-duty tools such as saws, drills, cast cutters, and a specialty tool called the bipolar forceps. Though they are classified as commodities, it is important to note their ease of use for their surgeons, their reliability and their longevity. 38

39 Conclusion Stryker has not come by their good standing within the medical instruments and supply industry by accident. They have instead spent both time and money developing a plan of action which would set them apart from their competitors. This plan of differentiation begins with their outstanding customer service and constant emphasis on innovation and then concludes with their high product quality and variety. 39

40 Formal Accounting Analysis Companies are required to follow the Generally Accepted Accounting Principles, or GAAP, when providing their financial statements. These requirements are the focal point of the business world. Every firm in the United States is required to present their company statistics in the GAAP approved way by a balance sheet, income statement, and statement of cash flows. Within these formats, there are rules as to govern how each item is found and recorded. GAAP are imposed on companies so that investors have a minimum level of consistency in the financial statements they use when analyzing companies for investment purposes. GAAP covers such things as revenue recognition, balance sheet item classification and outstanding share measurements. Companies are expected to follow GAAP rules when reporting their financial data via financial statements ( This is relevant to the investor because it makes the company display the most consistent information. When a company uses GAAP it can still try to misrepresent itself, however it makes it more difficult and there is the same data displayed for the public in different ways so that investors can double check and make sure the company is exactly what they say they are. The formal accounting analysis uses six steps in deciding a company s transparency level as well as the accuracy of the firm s financial statements. The steps are as follows: Identify key accounting principles, assess accounting flexibility as prescribed by GAAP, evaluate the accounting strategies, evaluate the quality of disclosure within the financial statements, identify red flags within the company s accounting records, and undo the accounting distortions. When used correctly, an accounting analysis can give a better view of the company using an unbiased source. Though a company can follow the policies set by GAAP, there is still room for accountant s to manipulate the numbers to make the company appear to be in a better financial state. An accounting analysis seeks to undue these distortions to give a more accurate view to potential investors. 40

41 Key Accounting Policies Stryker s key success factors are important pieces of information used in determining the critical accounting policies. These will then be used in giving a clearer assessment of the firm s value. The problem in determining the actual value of a firm is creative accounting, which is taking a subjective accounting method and using it to the firm s advantage. This causes a clouded view of a company s actual value and inhibits investors from making informed and accurate financial decisions. Since profits are used as a measure of a manager s performance, managers are influenced to distort profits with some of these subjective accounting methods. From the 10-K, Stryker s key success factors that were identified in the Firm s Competitive Analysis include: product and service differentiation, superior customer service, innovation, and superior product quality and variety. These are vital to the success of the firm. With over 60 years experience in developing solutions for orthopedic physicians, Stryker understands that our ability to deliver quality results starts with our relationship with you (Stryker.com). The subjective accounting policies that change the bottom line would be the recording of research and development, the utilization of operating or capital leases, and the disclosure and accounting methods used with pension and defined benefit plans. One ineffective method required by GAAP is that research and development be expensed, as opposed to capitalizing it. Since research and development is a large cost for Stryker, this gives an inaccurate view of the company. Also, one important accounting measure that would be important for Stryker, since they manufacture so many products, would be the recording of warranty expenses and reserves. Reading the customer reviews of their products would also be a good way of assessing their image. Recording Research and Development Stryker is always trying to be on the cutting edge of technological development with their products and they place a lot of emphasis on developing new products or improving existing ones to expand the scope of their business. This is a huge contributing factor to the growth of the Company. Therefore, a lot of time and money 41

42 goes into research, development, and engineering of new products. Stryker relies on close working relationships with many levels of medical staff in both hospitals and universities for the research and development of these products. In 2006, Stryker spent $324.6 million in Research, Development, and Engineering. This is 6.0% of total sales for the same year (Stryker s K). In addition, there were additional costs listed as Purchased In-Process Research and Development, which relates to acquiring companies whose products or technology focus were not quite ready to hit the market at the time of acquisition. These were not added to the total cost of Research and Development. For the sake of knowing what the actual cost of Research and Development was for those years, the table below outlays the accumulated Research and Development costs over the past three years. Total Research, Actual Expense Year Development, Purchased In-Process On R&D And Engineering R&D (Total plus Expense Purchased) 2006 $324.6 $52.7 $ $284.7 $15.9 $ $214.9 $120.8 $335.7 *all costs represented are in millions. While this does not affect how the expenses were treated, it gives us more insight as to what was paid in the name of research. Although all companies expense R&D, it is important to recognize the value of R&D on a business to business basis. Since the industry is based on high differentiation and superior quality, it is safe to say that these numbers are probably important to an analyst in terms of valuing the company against other investing options. Say that GAAP allowed R&D to be valued as an asset, then the theoretical value of R&D against three of Stryker s top competitors would be as shown: 42

43 THEORETICAL ASSET EQUIVALENT OF R&D Stryker Corp. $324.6 $284.7 $214.9 Zimmer Holdings, Inc. $188.3 $175.5 $166.7 Biomet, Inc. $85.0 $80.2 $65.0 Smith & Nephew plc NR NR NR NR= not reported *all costs in millions The Theoretical Asset Value was created by finding the expense actually put towards Research and Development. As you can see, the differences between Stryker, Zimmer Holdings, and Biomet in the amounts they invest in R&D are substantial and should be considered when valuing the Company. Also, the fact that one of the companies chose not to disclose their Research and Development expense shows that distortions in accounting statements create difficulty in valuing a firm. Either way, Research and Development is a driving force for the creation of value in the Medical Technologies Industry and it is a disadvantage to analysts not to see it listed as an asset. Capital and Operating Leases Another key distortion in analyzing accounting records is the effect of capital and operating leases on the overall liabilities of the firm. Capital leasing gives ownership a company and can give certain benefits, such as amortizing the asset over its useful life. Conversely, operating expenses are treated as a pure rent expense. Since firms normally would not want to show leases on the books and like to defer expenses, firms try to report as many operating leases as possible. Unfortunately for these firms, the Financial Accounting Standards Board has ruled that a lease should be treated as a capital lease if it meets any one of the following conditions: (1) if the lease life exceeds 75% of the life of the asset (2) if there is a transfer of ownership to the renter at the end of the lease term 43

44 (3) if there is an option to purchase the asset at a "bargain price" at the end of the lease term. (4) if the present value of the lease payments, discounted at an appropriate discount rate, exceeds 90% of the fair market value of the asset. The person who rents the asset (the owner or lessor) uses the same criteria for determining whether the lease is a capital or operating lease and accounts for it accordingly. If the lease is shown to be capital, the owner records the present value of future cash flows as revenue and recognizes expenses. For this reason, and the tax incentive for operating leases, many firms try to show as many operating leases as possible. Discerning their effect is important in gaining an accurate view of the firm. Not valuing the lease as an asset impacts the balance sheet for the firm. Stryker states that they have $62.1 million in operating leases for 2007, and a current maturity of long-term debt of $14.8 million, with no other long-term debt. This means that Stryker has paid off almost all of its long-term liabilities. Since it is hard to discern which is true from the amount of information their 10-K gives us, we will assume that they only have operating leases for the time being. With this in mind, that means that operating leases will account for 3.7% of Stryker s total liabilities and only 1.1% of total assets. We can make a logical assumption that Stryker is not making a substantial material difference in the value of the firm by using operating leases. With this being said, we can also conclude that Stryker is not intentionally trying to distort anyone s view of the firm s value. Defined Benefit Plans and Pension Plans Defined benefit and pension plans are liabilities to the firm as they represent a debt to be paid to an individual in the future. The amount of debt recorded is the present value of future expenditures, which makes it subject to a discount rate. Stryker, for the years of 2006 and 2007, has the discount rates of 4.1% and 4.4%, respectively. With current inflation sitting at 4.28% (inflationdata.com), it is good that Stryker is keeping up with current inflation. 44

45 An understatement of their discount rate will result in an overstatement of liabilities; in the inverse situation, overstating the rate would mean an understatement of liabilities. With the current T-bill rate sitting at 4.37% ( Stryker s discount rate can be increased over the next couple years. Firms like to estimate their future payments of pension and defined benefit plans conservatively over the inflation rate yet between the T-bill rate and the projected future returns on their investments. As the T- bill rate is considered the risk-free rate of return, it is reasonable to assume that the firm can make a return over that by investing in other securities. By taking a look at the 5-year return on the S&P 500, which is % (standardandpoors.com), it can be concluded that making enough from investments in the market to cover the discount rate for the pension plans would be fairly easy. Stryker conservatively states that they plan on a return in the 6.3% range, according to their 10-K. This seems relatively low. We can safely assume that Stryker is conservatively overstating their liabilities. Conclusion According to the information regarding the Key Accounting Principles and the ways in which they have been evaluated above, we can reasonably conclude that Stryker is making little to no bias in their accounting methods and disclosure principles. Their full and untainted disclosure of their research and development expenses is logical compared to the rest of the industry, especially when taking their market position into consideration. Stryker s use of operating leases and lack of long-term debt or capital leases is a clear representation of their financial stability and efficiency. And the planned out amounts of pension plan benefits and returns shows that they are utilizing a fair method of projecting future liabilities. 45

46 Accounting Flexibility One of the most important pieces of information used to evaluate a company is the accounting procedures used to develop the income statement, balance sheet and statement of cash flows. The flexibility of accounting refers to how companies can alter information to reflect either an increase or decrease in the actual standing of the company. Certain policies are closely watched by the Federal Accounting Standards Board (FASB), such as research and development expenses, but other areas are left more to accountants to determine. This is where accounting numbers can be misconstrued and stretched to appease shareholders and executives. The intentions behind the accounting flexibility section are used to determine how accurate Stryker and the industry are at representing different aspects of the financial statements. Flexibility of Research and Development The area of research and development is closely watched by the FASB and the SEC which leads to little flexibility among different firms. All research and development costs are required by GAAP to be expensed, which can dramatically mislead financial statements. In most technology driven industries, large amounts of research and development are necessary in order to thrive over their competition and maintain market share. The medical instruments and devices industry is in accordance with this philosophy, which is unfortunate to the financial statements. The following chart explains what happens when research and development is expensed as opposed to capitalized. ASSETS = LIABILITIES + EQUITY REVENUES -- EXPENSES = NET INCOME U O U N O U U=Understated O=Overstated N=No Effect 46

47 With research and development being directly related to revenue, these expenses should be capitalized as an asset and amortized. Yet, with no accounting flexibility in this area, these costs have to be expensed making technologically dependent companies look undervalued. Flexibility of Capital and Operating Leases In the area of capital and operating leases, there is a much greater flexibility option for the accountants to decide upon. Companies can decide between two different types of leases that have different components and can alter the financial statements dramatically. Capital leases allow the company to take direct ownership of the firm and its equipment or buildings with leasing liabilities. Operating leases allow the leased asset to be leased to the firm for a number of years and then returned back at the end of the leasing period. The difference between these two types of leases effect the amount of liabilities and assets indicated on the balance sheet and the amount of leases actually possessed by the firm. ASSETS = LIABILITIES + EQUITY REVENUES -- EXPENSES = NET INCOME U U N N N N U=Understated O=Overstated N=No Effect The medical instruments and devices industry can utilize both capital and operating leases. Most companies in this industry try to minimize the amount of leases because factories and production facilities are owned and presented as an asset on the balance sheet. The only areas of Stryker that are leased are the various manufacturing and office facilities and equipment that are categorized as operating leases. Stryker expects their leases to lower year after year until there is not any long-term debt left on the books. 47

48 Pension Plans Pension (defined benefit) plans are for employees retirement needs. The amount the company spends each year concerning their employees retirement funds are determined by the number of employees, average age of retirement for employees, the number of employees reaching the retirement age, and a discount rate configured by accountants. This amount of money spent on pension plans can significantly affect the balance sheet of the firm by increasing or decreasing liabilities. The total liabilities on the balance sheet can be identified as an aggressive or conservative approach to stating the pension plans of the employees. If firms choose to understate pension plans on the liabilities section of the balance sheet, then the firm can appear more profitable than they actually are. In accordance with GAAP, companies are supposed to make their accounting numbers as conservative as they can, but pension plans is an example where this rule can be violated. With the pension discount rate and the total liabilities being inversely related, firms can easily misconstrue the amount of money allocated to liabilities on the balance sheet by simply increasing or decreasing one of these items. ASSETS = LIABILITIES + EQUITY REVENUES -- EXPENSES = NET INCOME N U O N U O U=Understated O=Overstated N=No Effect Above, the over-under analysis displays the relationship between each section of the balance sheet and income statement and how an increase in pension plan funding can affect every aspect of the financial statements. Each firm has the ability to increase or decrease the value of pension plans due to the flexibility GAAP has allowed with little or no consequence. This flexibility does allow companies to better describe their economic standing in the industry as well as diversify themselves among the competition, but needs to be closely monitored in that the firm has more opportunity to distort their financial position. 48

49 Evaluate Accounting Strategy There is a great importance in evaluating the accounting strategy that each firm chooses to use. Management has a large financial investment in the company whether that is through being a shareholder or an interest in job security. With this interest in the firm, managers have incentives to distort the financial situation of the firm, which creates a larger appeal. Management can accomplish this by distorting revenues and expenses to their benefit. Accounting areas that are prevalent to the medical instruments and supplies are research and development, capital and operating leases, and defined pension plans. These areas can be misconstrued to overvalue the firm and make it look more profitable to invest in. A key indicator of how accurate a firm is being in their financial statements is to consider the transparency and conservatism the firm uses. The more information a firm provides to the public, allows investors to decide how true their finances are. Research and Development The medical instruments and supplies industry focuses on research and development as an accounting policy that is not flexible to GAAP standards. With Stryker being an innovatively thriving market, their financial statements are not reflected as such. Stryker spends six percent of all revenue on research and development and is not able to capitalize any of this money due to accounting policies. Therefore one of their largest assets, research and development, has to be expensed lowering the assets of the firm. In innovation driven industries, research and development is forced to be expensed, which can cause management to alter financial statements to alleviate the large amount of expenses. With research and development not being recognized as an asset, expenses are overstated and net income is understated because these two financial items are inversely related. With net income being understated, that can dramatically affect the view of the company to investors. Stryker and its competitors all 49

50 spend millions of dollars on research and development annually. With GAAP s restriction on expensing R&D, management lacks flexibility that makes firms overcompensate for expenses and assets in some other way. This causes a huge misrepresentation on the financial statements and misleads investors. Capital and Operating Leases A company chooses to classify leases as capital or operating leases. Liabilities and expenses can be affected if these leases are not recorded correctly. Stryker and its competitors record their leases as operating leases most of the time because it keeps the lease off the balance sheet minimizing liabilities and expenses. Companies in the medical instruments and supplies industry experience such a large amount of expenses just because of research and development that they need to minimize other expenses as much as possible which is a direct result of the use of operating leases. If management manipulates the financial statements to reflect a more positive quarter for the company, they can do this by recording leases as expenses and not as a liability. This will reduce the amount of liabilities on the balance sheet and increase expenses on the income statement. Many companies do this to represent the company more highly, but it is against GAAP and they can be held liable for these accounting adjustments. Stryker and its competitors have in the past and continue to represent their operating leases as liabilities on the balance sheet to accurately value their company. Pension Plans Companies with many employees incur a great amount of expenses every year in the form of pension plans. Each employee seeks benefits for health care and retirement that are expensed to the company. Pension plans, as explained above, are decided by many factors including the number of employees, discount and growth rates, number of employees reaching the age of retirement and the average age an employee retires with the firm. The estimates management makes to decide how much to spend on pension plans are just that, estimates. An increase or decrease in the 50

51 discount rate per employee can drastically alter the amount of money expensed on the balance sheet. Pension plans are great for employees of the company, but are costly to firms and investors. Investors look into the discount rate and how it compares with competitors. Stryker has a discount rate lower than its competitors, Smith and Nephew and Biomet, which increases liabilities and expenses making Stryker look like the more conservative company. Stryker s competitors may have a higher discount rate in order to compensate for some other liability or expense for the year. Management is able to manipulate pension plan expenses especially due to more flexibility with accounting principles. Managers are influenced by shareholders and therefore are willing to increase or decrease the amount of expenses and liabilities concerning pension plans. Conclusion The accounting strategies used by the firms are a great way to interpret the daily activity for investors and management to overview. But the downside is that managers can manipulate areas of the financial statements to make a firm appear more profitable. With increased pressure from shareholders and top level executives, managers feel the need to adjust finances in order to have job security and a protected retirement fund. Research and development, capital and operating leases, and pension plans are common ways for managers in the medical instruments and supplies industry to manipulate finances. These activities devalue a firm and make them appear financially unstable. 51

52 Quality of Disclosure Qualitative Disclosure is described as how useful the information firms provide in their financial statements is to business analysts and potential investors. Managers of companies have some flexibility in this area and can make financial statements more or less easy to understand depending on how they choose to disclose information. The better the qualitative disclosure the more confidence investors have in their analysis which makes their conclusions more reliable. On the other side, some companies try to hide flaws in the company by providing inadequate disclosure. Although accounting rules require a certain amount of minimum disclosure some companies refrain from full disclosure to keep from giving away their strengths or to hide their weaknesses. Other firms disclose large amounts of useless information in an attempt to cover up problems they may be having. Therefore, disclosure is a very important part of accounting quality. Qualitative Analysis Stryker Corporation does an adequate job disclosing information about all aspects of the company. Their financial reports are very transparent and provide a good understanding of the firm s recent performance and financial position. Management clearly describes what is going on within the industry, their competitive position, and plans for the future. In their annual report or 10K, Stryker gives a detailed explanation of how each segment of the company is doing and how much of each product they sale. They breakdown their company by each type of product such as orthopedic products or hip and knee replacements, and then disclose what is going on with each one. A large portion of Stryker s sales are done internationally so they are very careful to account for fluctuations in currency rates in figuring net income. They cautiously explain that financial results can be greatly affected by changes in currency rates or weak economic conditions in foreign markets. In the Other Matters section of the 10K, Stryker informs investors that they have entered into foreign currency exchange contracts and that they are exposed to credit loss in the event of 52

53 nonperformance by other parties. Stryker also does a good job of using footnotes to explain the exact accounting policies that they use to base their assumptions. For example, they noted in 2006 that they changed their method of accounting for retirement plans with the required adoption of Statement of Financial Accounting Standard No. 158 (Stryker K). In addition to the footnotes Stryker tells exactly which accounting rules they use throughout the 10K. Another measure of Stryker s quality of disclosure is that they are very forthcoming with respect to bad news. For example, in 2007 the Company disclosed that the U.S. Securities and Exchange Commission made an informal inquiry of the Company regarding possible violations of the Foreign Corrupt Practices Act in connection with the sale of medical devices in certain foreign countries (Stryker K). However this is no cause for alarm from an investor point of view and should have no significant effect on the company. It is also worth mentioning that research and development is well disclosed by Stryker, as well as all firms within the industry. R&D expense is very important in this industry because it directly affects sales and profitability. Companies compete on product quality and innovation which is a result of R&D. Stryker s R&D expense represents over 6% of every sales dollar, and since GAAP requires that entire amount to be expensed it has a huge impact on net income. Some other important areas deal with leases and pension plans. According to the 10K Stryker only uses operating leases for buildings as opposed to capital leases to keep them off of the balance sheet. They also disclose adequate information concerning pension plans. However, Stryker uses a smaller interest rate to compute the present value of these plans than do their competitors. Quantitative Analysis Quantitative analysis is intended to determine how the actual numbers in the financial statements relate to each other and aids in spotting specific problems in accounting disclosure. Due to the fact that GAAP allows managers to have some flexibility in how they report different accounting numbers, investors and analysts should pay careful attention to all of the disclosure details checking them for distortions. 53

54 The best way to do this is by using sales manipulation and expense manipulation diagnostic ratios. Sales manipulation compares net sales to cash from sales, accounts receivable, inventory, unearned revenues, and warranty liabilities. Expense manipulation compares sales to assets, changes in operating cash flows to operating income and net operating assets, and pension and other employment expenses to selling, general and administrative expenses. Sales Manipulation Diagnostics We start the sales manipulation diagnostics by taking the five most recent years of information submitted by each company, and then turning those numbers into useful ratios for the investor. By doing this, investors will be able to see how their company is doing in regard to some areas of the Company s 10-k that might raise questions. In addition, investors will be able to see the trends set by all competitors in the same market. If one company has a significant difference in one area, the investor should be wary of the potential for red flags. 54

55 Net sales/cash from sales This ratio is found by taking sales divided by cash from sales. It tells the investor if the company s cash received from sales is equal to the amount of sales minus all expenses, including allowance for bad debt. The ratio should be close to 1:1. This shows that all the cash they collected came from all the sales the company expected to receive cash from within that year. All companies are around 1 and therefore show no sign of manipulating the accounting cycle to make their company look to be in better condition than in actuality. 55

56 Net sales/accounts receivable This ratio is found by dividing net sales by accounts receivable. This lets the investor know how much of the company s net sales are still in accounts receivable and are expected to be collected on a future date. From this graph we can see that Stryker has a higher ratio then it s competitors. This is a positive since a low ratio indicates the longer accounts receivable are withheld, the longer accounts receivable are not received the greater the chance it will not be received at all. There is no definite correlation to the industry trend, Due to the fact that each company in the industry is not very similar. Medical technology companies although in the same industry are highly different in terms of operations and sales. It seems all companies have maintained the steady growth in accounts receivable and Stryker is still achieving a higher ratio than the other companies in the market. There are no red flags that show any sign they have tried to alter their accounting policies. 56

57 Net sales/inventory This ratio is found by dividing net sales by inventory. This ratio is intended to show investors how efficiently the company is using its inventory. The higher the ratio the better the company is in terms of efficiency. Stryker seems to have the highest ratio compared to its competitors which means they use their inventory more efficiently and therefore we could assume they have a lower inventory cost. Stryker seems to be gradually increasing this ratio just as the other companies in the industry. From this graph we can see that the industry has been increasing and decreasing similarly to each other. This shows that they have not tried to forge inventory or sales to misrepresent their accounting cycle. Conclusion The overall quality of information found by these ratios regarding sales manipulation diagnostics indicates that Stryker has not in any way tried to overstate the value of the firm. The net sales by cash from sales showed us they were around 1:1 supporting each other. The net sales by accounts receivable showed us that Stryker and Zimmer might be close to substitutes but Stryker still has an edge over the market. Also, all companies are following the same trend as of the last 3 years. The firms could have overstated the accounts receivable to make it look like they have large amounts of 57

58 cash in receivables. Nevertheless, it seems that Stryker has been honest regarding this scenario. The net sales by inventory ratio show that all companies have different amounts of inventory at different points but seem to be slowly increasing these numbers. From all the information above for the past five years we can say that Stryker has in no way tried to alter the accounting cycle to look better then actual value. More importantly for an investor, Stryker is above all other companies in each of the ratios. Sales Manipulation Diagnostics (cont.) Stryker Net sales/cash from sales Net sales/accounts receivable Net sales/inventory Zimmer Net sales/cash from sales Net sales/accounts receivable Net sales/inventory Biomet Net sales/cash from sales Net sales/accounts receivable Net sales/inventory Smith & Nephew Net sales/cash from sales Net sales/accounts receivable Net sales/inventory

59 Expense Manipulation Diagnostics We start the expense manipulation diagnostics just like the sales. We take the most recent five years of information and complete ratios to see how the company is doing in regard to the trends set forth by the industry. By doing so, it is easy to see if a company has made a change to the books to alter the appeal to investors. Along the way if there is a significant difference in a company compared to the trend, one might want to look more closely for a potential red flag. Asset Turnover The asset turnover ratio is found by dividing sales by assets. This ratio is important because it shows how well the company is using its assets to achieve revenue. As shown from the graph, no company has had any huge jumps over the last five years which indicates no red flags for the industry. Stryker seems to have a good ratio but has gone down over the past five years. The decrease is not so significant to sound alarm but could be a direct correlation to the amount of money Stryker spends on research and development. Zimmer has been on a steady incline which indicates the company has been using their recourses for a favorable gain. Stryker seems to be in no danger with using their assets efficiently, and does not need to change production. The 59

60 slow steady line shows that Stryker has not tried to alter the company value by overstating total assets. Change in Cash Flow from Operations/Operating Income This ratio is found by dividing the change in cash flow from operations by operating income. This lets the investor know how well the company is doing for that year in productions. In this industry the ratio can change dramatically due to major activities for the year, or putting in a new form of operations. The slight decrease in this case could once again be because Stryker uses such large amounts of cash in terms of operations for research and development. Stryker has no red flags that are noticeable from this ratio and is almost at a safe and stable one to one. There is no significant change that would lead me to believe Stryker is altering their accounting cycle. 60

61 Change in Cash Flow from Operations/Net Operating Assets This ratio is found by dividing change in cash flow from operations by net operating assets. Net operating assets are fixed assets, such as property, plant and equipment. The higher the ratio, the higher the return on the net operating assets. This is important because it shows how well the company is using its fixed assets. If the ratio were low it could imply that the company has to high of fixed assets and the company should change their net operating assets before it becomes a bigger problem for the company. From the graph, we can conclude that Smith & Nephew has a higher return than other companies on net operating assets. This could be due to the fact they are smaller than the other companies and have a much smaller amount for fixed assets. Stryker has done a decent job of staying close to a one to one ratio over the past five years. This is important because it means the company does not need to change their form of operations in order to achieve a positive ratio. There is no true industry trend due to the fact these companies are so different in terms of operations and fixed assets. From this information, Stryker shows no sign of adjusting the books to make the firm seem more valuable than reality. 61

62 Pension Expense/Selling, General, and Administrative This ratio is found by dividing the pension expense by the selling, general and administrative cost. This lets the investor know how much money the company is spending to pay retired workers now and in the future. You do not want this ratio high because then that tell us the company is wasting a lot of money, and even more important that maybe the pension plan the company uses is bad and could ultimately get worse in time. With a lower ratio the company could be using that money to invest or put back into the company. The industry trend has been on a slight rise which can indicate a rise in pension expense. We can tell that Stryker has maintained a low average which is increasing but not large enough for concern. More importantly the company has had a steady average which indicates no sudden changes in order to misrepresent the accounting cycle. Conclusion The overall quality found from these ratios concerning expense manipulation diagnostics indicates that Stryker has in no way tried to alter their accounting cycle to make the company look more valuable then reality. The asset turnover shows us that 62

63 Stryker has maintained a close ratio of 1:1 and with no significant jumps in the numbers; we realize Stryker has been depreciating and writing off their expenses correctly. Change in cash flow from operations by operating income shows us that they are supporting each other. With a close ratio of one there is no cause for alarm there. This goes as well with change in cash flow/net operating assets. The company is doing correctly and has been over these last five years. This lets the investor know that Stryker has no concerns when dealing with fixed assets that might surface in the future. The pension expense/ selling, general and administrative cost indicates that the company is not losing large quantities of money on retired workers and shows no sign of a problem with the pension plan set forth by the company. The ratios prove that Stryker has been honest to the public with the information they have been posting for their accounting cycle. 63

64 Expense Manipulation Diagnostics (cont.) Stryker Asset Turnover CFFO/OI CFFO/NOA Pension Expense/SG&A Zimmer Asset Turnover CFFO/OI CFFO/NOA Pension Expense/SG&A Biomet Asset Turnover CFFO/OI CFFO/NOA Pension Expense/SG&A Smith & Nephew Asset Turnover CFFO/OI CFFO/NOA Pension Expense/SG&A NA NA NA NA NA 64

65 Potential Red Flags Using qualitative and quantitative measure, one can find potential red flags by finding severe and unexplainable changes. When the unexplained material could potentially sway an investor s interest in the company, that material must be further looked into. Normally, a high level of disclosure means fewer red flags. However, a company can also disclose too much information as to mask the red flags. Stryker discloses adequate information to determine the value of the firm but does not do this in excess. Because of this, the red flags were few in quantity. One red flag is the discount rate Stryker uses for their defined benefit retirement plans as compared to their competitors. For contrast: 2006 Stryker Corp. Zimmer Smith & Biomet Inc. Holdings Inc. Nephew Discount Rate 4.1% 5.84% 5.8% 5.03% 2007 Stryker Corp. Zimmer Smith & Biomet Inc. Holdings Inc. Nephew Discount Rate 4.4% 6.14% % *The 10-K for each company Stryker s discount rate is considerably lower than that of Zimmer Holdings and Smith and Nephew. There is a smaller gap in the discount rate of Biomet versus Stryker, but it is enough to influence their stated profits. For example, an increase in the discount rate would reduce pension plan deficit while a decrease would increase 65

66 deficit. An increase in discount rate would decrease profit before taxation while a decrease would increase it. How Stryker comes up with their discount rate was not discussed in their 10-k. However, Zimmer Holding s 10-k states that their discount rates were determined for each of their defined benefit retirement plans at their measurement date to reflect the yield of a portfolio of high quality bonds matched against the timing and amounts of projected future benefit payments. Stryker also chooses to use operating leasing over capital leasing. From their own 10-K, The Company leases various manufacturing, warehousing and distribution facilities, administrative and sales offices as well as equipment under operating leases. It is curious to note that they only use operating leases though. However, after an examination of Stryker s operating leases, one can conclude that these leases were not significant when compared to their current liabilities. Also note that Stryker s competitors, specifically Zimmer Holdings and Smith & Nephew also chose to use operating leases over capital leases in their business. As their main competitors also choose to use the same methods of leasing, this can be concluded to be less of a concern to potential investors. Investors should continue to remain aware of the leasing obligations as they will affect the outcome of total liabilities and assets depending on how the company chooses to lease their land and equipment. The diagnostic ratios show no warning signs or red flags for the potential investor to be concerned with. The other irregularities were explained throughout the rest of the 10-K. For instance, Stryker Corporation's 10-K stated that net sales increased 11% in 2006 to $5,405.6 million from $4,871.5 million in Net sales grew by 10% as a result of increased unit volume and changes in product mix and 1% as a result of higher selling prices. They follow this pattern throughout the entirety of the 10-K leaving all questions asked of them answered in full. Kroger also continually updates their levels of accounting as directed by the Financial Accounting Standards Board (FASB). This is their way of continually improving their methods of disclosure for their investors. 66

67 After a careful review of Stryker s financial statements, it can be concluded that there are few red flags for possible investors to be concerned about. The main concern would be the lower discount rate that the company chooses to use in effort to increase their before profit taxation. Stryker does a very good job of disclosing through their key accounting procedures and continues to increase this level of disclosure as years pass by implementing new FASB standards. Undoing Accounting Distortions and Irregularities When items which could potentially distort the accounting statements come to light, it is important for analyst to undo them so as to give a more accurate representation of the company to investors. As the ratios deemed that Stryker presented an accurate view of their company through their financial statements, no distortions or needed to be undone. Though Stryker had some areas of concern regarding their post retirement benefit plans, simply disclosing how they came up with their discount rate or raising their discount rate to mirror their competitors would suffice in fixing this potential red flag. Their operating leases were deemed to be of little concern to investors. The Company also continually increases their levels of disclosure through implementation of new FASB accounting policies. Therefore, it can be concluded that Stryker has no one red flag that needs to be reevaluated at this time. 67

68 Financial Analysis, Forecast Financials, and Cost of Capital Estimation Introduction In this portion of our report we use ratio analysis, forecasting financials, and cost of capital estimation to better understand the financial position of Stryker. The financial ratios are used to determine the firm s liquidity, profitability, and capital structure as well as credit risk. We then make a ten-year forecast of the financial statements based on the growth rates found from the past four years of financial statements. Finally we will calculate the weighted average cost of capital for Stryker and use a model to justify our estimations. Liquidity Ratio Analysis The set of liquidity ratios are used to determine a company s ability to pay off short-term debt. The higher these ratios are, the easier the company can meet their short term debt obligations. This is important to all companies, but even more important for those seeking the use of lenders. The current ratio as well as the quick ratio shows if the company has any liquid assets. If these ratios are to low the company may have a hard time finding a lender and even more importantly paying current liabilities. On the other hand, if these numbers are extremely high it shows the company may be holding too much cash that could be used to help the company grow. The inventory turnover, inventory days, and working capital are calculated to show how well the company is operating. The ratios should be compared to other companies in the industry. If the inventory turnover is too low this implies poor sales which cause an excess of inventory. If this ratio is too high it implies high sales or poor buying. The better these ratios are, the better the operating efficiency of the company. The accounts receivable turnover and day sales outstanding are used to show how well the company uses their assets and how long it takes to turn sales into cash. Below we listed ratios for the last five years. They will be in a box above the corresponding graphs. As 68

69 we mentioned earlier not all high ratios are signs the company is doing well, but generally high liquidity ratios are preferred. Current Ratio The current ratio is found by dividing current assets by current liabilities. In general it is best to have a ratio higher than one. This means the company has enough short term assets to pay for short term liabilities. This is also a good situation for a company who needed to borrow money. Having a higher ratio as Stryker does helps eliminate risk the lender would encounter in the process. As you can tell from our graph Stryker has had an increase in current ratio over the past five years. This is a result of them increasing short term investments and choosing to hold a large amount of cash. The spike from 2006 to 2007 is a direct indication of their increase in short term investments; that rose from $998,200 to $2,120,300. In conclusion, although Stryker has a fairly high current ratio they are consistent with other companies in the industry. This ratio shows that Stryker is in good financial health and could easily meet short-term obligations. 69

70 Quick Asset Ratio This ratio is very close to the current ratio except it uses only the most liquid current assets called the quick assets. We found this ratio by dividing the quick assets from current liabilities. The quick assets include cash, marketable securities, and accounts receivable. Inventory is excluded from this ratio because it can t be converted into cash quickly enough. The trend is about the same for the past five years, all companies seem to be on a steady incline in this ratio. Stryker is consistent with the industry for this ratio as well and have a quick ratio of 2.5 in 2007 which is fairly safe. The only company that differs from the others is Biomet which is a relatively new company that is trying to establish itself. 70

71 Accounts Receivable Turnover We found the accounts receivable turnover by dividing sales by accounts receivable. This ratio is a useful tool in determining how effective a firm is at extending credit and collecting debts. A low ratio implies a firm should revise their collection policies. Stryker is in good condition with a ratio higher than the other three companies. This shows that Stryker is efficient in collecting its accounts receivables. It is concerning that Stryker s ratio went down from 2006 to 2007 while its competitors went up. This could be explained because Stryker sold more products on credit in They still lead the industry in this ratio and are in good shape as far as collecting debt. 71

72 Days Sales Outstanding This ratio is calculated by taking 365 days and dividing it into accounts receivable turnover. This ratio shows the investor how long it takes for a company to collect money from the sales. A small Days sales outstanding number means that it takes a company fewer days to collect accounts receivables. A large Days sales outstanding number means that it takes longer to collect accounts receivables. These numbers are important because firms want to collect cash as quickly as possible. Firms like to collect cash as soon as possible so they can reinvest the money and make more sales. Stryker has the lowest DSO of all its competitors which means they collect their accounts receivable s quickly and efficiently. 72

73 Inventory Turnover This ratio is calculated by dividing cost of goods sold by inventory. This lets the investor know how well the operating efficiency is in the company. A low turnover implies poor sales which lead to excess inventory. A high ratio implies either strong sales or ineffective buying. The industry trend is about the same for all companies the only difference is that Stryker s ratio is much higher. This could be that Stryker has really strong sales compared to its competitors or that they do a better job controlling inventory levels than do their competitors. In this case having a higher ratio is a good thing because it tells us that the company is operating efficiently and they do not have as much money tied up in inventory should prices fall or products become obsolete. 73

74 Days Sales of Inventory This ratio is found by dividing 365 days by the inventory turnover. This lets the investor know how long it takes the company to turn its raw materials into sales. Stryker s ratio is good because it shows it takes longer for the rest of the industry to gain revenue from their inventory. Stryker s DSI is significantly lower than the rest of the industry because their inventory turnover is higher. This is a result of them holding fewer inventories and having strong sales. The DSI is also extremely consistent for Stryker which could be a result of them doing a really good job controlling their inventory. The other firms in this industry all have similar DSI. 74

75 Working Capital Turnover Working capital turnover is found by first subtracting current assets from current liabilities, then dividing it into sales. Working capital turnover is a ratio that shows how well firms use money from their operations to generate sales. Generally, a company wants a high working capital turnover because it shows they are generating large sales compared to the money they are using. Stryker since 2003 as well as the entire industry have had a large decrease in working capital turnover. This can be explained by large increases in current assets each year and is probably not much of a concern. 75

76 Cash to Cash Cycle The cash to cash cycle is a ratio of days in inventory divided by days in accounts receivables. This shows how a company balances their cash flows on an annual basis. Any ratio over one tells an investor that there is a longer time span for inventory than accounts receivable. Stryker s low cash to cash cycle illustrates that they have more money in accounts receivable waiting to be turned into cash. Having a lower cash to cash cycle illustrates how liquid a company is compared to its industry. Conclusion Stryker s ratios show that they are financially stable and can be relied on to pay off short-term liabilities. None of their ratios showed any liquidity problems and were favorable compared to their competitors. Stryker is consistent with industry trends and appears to be more liquid in most areas. Stryker has high current and quick ratios which shows they can easily pay off short-term debt. They have low Days Sales Outstanding which shows they quickly collect accounts receivables. They also have a low Days Sales of Inventory which means they convert raw materials to sales quickly. 76

77 Profitability Ratio Analysis Profitability Analysis is used to determine how profitable a company is in an industry based on their sales. Profitability ratios illustrate how efficient companies are at turning profits compared to their expenses and other costs for a specific period. The profitability ratios include gross profit margin, operating profit margin, net profit margin, asset turnover, rate of return on assets and rate of return on equity. Each ratio is calculated as a percentage of total sales. Gross Profit Margin This ratio is calculated by dividing gross profit by sales. Gross profit margin tells us how much of sales are left after the cost of goods sold is subtracted. High gross profit margins occur when firms are able to sell products at a high price or have a low COGS. Low gross profit margins are caused by a low sales price or high COGS. Stryker has a lower gross profit margin than their competitors which means they are paying more for their products or the raw materials it takes to produce them. From the graph above we can also tell that there are structural differences between Stryker and its 77

78 competitors. In the medical instruments and supplies industry or the medical industry in general it is very difficult to find competitors that do the exact same thing. The large differences in GPM we show us that Stryker and its competitors don t compete in the exact same markets. Smaller companies like Zimmer and Smith & Nephew are able to have a higher GPM because they do not sale as many medical products as Stryker or Biomet. Stryker s gross profit along with sales have been on a constant incline up, which means that from an investor standpoint Stryker is doing well. Operating Profit Margin This ratio is calculated by dividing operating income by sales. Companies want this ratio to be high because it shows an efficient and profitable way of business. By minimizing general, selling and administrative costs, companies will have a higher OPM. Operating profit margin gives investors an idea as to how much a company makes before interest and taxes on each dollar of sales. From the graph above, the first thing we can tell is that there are definite structural differences between Stryker and its competitors. We can tell from the differences in OPM and the recent trends that these 78

79 companies do not compete in the exact same market segments. Stryker and Smith and Nephew seem to have similar trends while Zimmer and Biomet move following the same trend or pattern. For example, from 2006 to 2007 the OPM for Zimmer and Biomet dropped significantly while Stryker was able increase. Another thing we noticed is that Smith and Nephew has a lot higher expenses than Stryker. They were able to maintain a higher GPM than Stryker yet have a smaller OPM. They have similar trends which show us Stryker does a good job managing expenses. Zimmer s high ratio is due to the fact they maintain small operating expenses. Stryker also spends more money on research and development than its competitors each year which could contribute to them have a smaller OPM. In the medical instruments and devices industry, companies must place a higher emphasis on research and development; much more than Zimmer us willing to financially put forth. So this ratio might seem like Zimmer is performing better then Stryker but that just depends if the investor does not believe research and development is an important factor for the company s future. 79

80 Net Profit Margin This ratio is found by dividing net income by sales. This ratio shows us how much of every sales dollar is turn into net income. The first thing we know is that companies in this industry operate with fairly high Net Profit Margins of 15 to 25 percent while companies like Wal-Mart make millions with NPM of less than 5 percent ( This reaffirms that our industry sells specialty products versus commodities. Like with GPM and OPM, from this graph we can also still see the structural differences between the firms. The huge profit margin for Smith and Nephew in 2006 can be thrown out because they sold off part of their company. This sell gave them an extremely high net income. 80

81 Asset Turnover Asset turnover is a company s sales divided by total assets. This ratio measures a firms efficiency at using its assets to generate revenue. Stryker has a very consistent asset turnover because they directly relate their asset purchases and uses to how well they do in revenue for the year. With most companies in this industry averaging around a dollar, Stryker leads above its competitors. The great decline from 2003 to 2004 for Zimmer Holdings is their decision to invest in numerous machinery and equipment which greatly increased their assets, altering asset turnover tremendously. 81

82 Return on Assets The return of assets is found by using the net income of one year divided by the total assets of the previous year. This ratio allows you to compare how profitable the company was this year without adding new value of recent assets. Zimmer s large decline in 2004 was due to their massive increase in total assets and significantly lower net income. Stryker continues to remain consistent compared to its competitors, which illustrates great stability of the company. Smith and Nephew s large increase in ROA in 2006 was due to them selling off part of the company. 82

83 Return on Equity The last profitability ratio indicates the relationship between the net income of the current year and the total equity of the previous year. An investor can see that Stryker has had a stable return on equity with a recent increase in the last couple of years above its competitors. This shows that Stryker is receiving a lower return because they finance with little equity. Conclusion From the profitability ratios, any investor can see that Stryker has remained stable and profitable. With consistent ratios averaging among their competitors in four out of six ratios, Stryker proves to be a strong leader in this industry due to its continued stability. Stryker had the highest asset turnover and ROA and ROE in the industry in 2007 which shows that they are being profitable. They have lower profit margins than some of their competitors but we believe this can be explained by structural differences and market segmentation. 83

84 Capital Structure Analysis The capital structure analysis of a company shows investors where firms get the money to finance their operations and the money they use to grow. These ratios show investors how much debt companies choose to have and how much funding comes from within. The mix of short and long-term debt is evaluated in this analysis. The ratios we used in this analysis include the debt to equity ratio, times interest earned, and the debt service margin. Debt to Equity Ratio The debt to equity ratio is determined by dividing the total debt by the total equity. This ratio explains the financial leverage of companies in the industry. Higher debt/equity ratios mean companies choose to hold large amounts of debt to finance their growth where smaller D/E ratios mean companies are mostly financed by equity. Stryker has maintained a stable debt to equity ratio averaging.446 which relatively close to Zimmer and Biomet. This means Stryker borrows less than half of the amount 84

85 of equity they have which seems conservative and does not pose any capital structure risk. Smith and Nephew on the other hand from 2003 to 2005 had a D/E ratio of over one. In some industries it may be common to have this high of D/E ratio, but since their ratio was so much larger than their competitors this might be extremely risky. In 2006 Smith and Nephew sold part of their company which makes the sharp decline hard to evaluate. Times Interest Earned The tool, times interest earned, is used to show investors a company s ability to meet its debt obligations (Investipedia.com). It is calculated by taking operating income and dividing it by total interest. In the medical instruments and supplies industry, most companies do not accrue interest because of their low levels of debt. Companies either experience a high interest expense ratio (meaning they had very little interest expense) or zero for the ratio (indicating that there was no interest at all). From these results we can gather that firms in this industry do not rely heavily on debt financing. They have no problem at all meeting their debt obligations. 85

86 Debt Service Margin The debt service margin is a measurement of the operating cash flows of a company divided by short term debt that comes due within the year. This ratio tells investors how easily companies can pay off their short-term debt with the money they make from their operations. Altman Z-score The Altman Z-score is a credit risk model that calculates the chance of a firm going bankrupt. Lenders analyze these scores when trying to determine whether or not to lend to a particular company. According Business Analysis and Valuation by Palepu and Healy, a score of 1.81 or less predicts a company will go bankrupt. A number ranging from 1.81 to 2.67 is a gray area that indicates companies are high risk and classifies them as undetermined. Z-scores that are larger than 2.67 show that 86

87 companies are in good financial shape and pose little risk of bankruptcy. The Altman Z- score is calculated according to this formula: 1.2(Net Working Capital / Total Assets) + 1.4(Retained Earnings / Total Assets) +3.3(EBIT / Total Assets) + 0.6(Market Value of Equity / Book Value of Total Liabilities) + 1.0(Sales / Total Assets) Altman Z Score WC/TA RE/TA EBIT/TA Close Shares Outstanding MVE BVL Mve/BVI Sales/TA Z-Score Stryker s Altman z-scores range from a high of in 2006 to a low of 8.10 in 2003 which show that according to this model the company is in very little risk of going bankruptcy. The scores were quite a bit lower in 2003 and 2005 because Stryker had a lower market value of equity in these years caused by a lower share price. The market value of equity in 2003 was also lower because they had fewer shares outstanding. The numbers for these years were still really high and cause no reason for concern. 87

88 Conclusion The capital structure of Stryker is similar to that of its competitors in the industry. With little to no interest, small current long term debt, and high equity, Stryker has no problem meeting its debt obligations. They are mostly equity financed like others in the industry and have no capital structure risk. Internal Growth Rate The internal growth rate of a company tells investors the highest rate a company can grow without obtaining money from outside sources. This rate is found by multiplying the return of assets times 1 minus the dividend payout ratio. Stryker and its competitors have maintained a stable IGR in this industry and are all pretty close together. Without fail, Stryker continues to remain constant in that it has not experienced any major increase or decrease in IGR in the last five years. In 2007 Stryker had the highest IGR in the industry which shows that it does a good job financing itself. Smith and Nephew sold part of their company in 2006 skewing that 88

89 IGR, and Zimmer had very few assets in 2003 which is the cause for their really high IGR. Sustainable Growth Rate The sustainable growth rate measures how much a firm can grow without borrowing more money (Investipedia.com). SGR can be found by multiplying the IGR times 1 plus the debt to equity ratio. Like with IGR Stryker s SGR is right about the industry average. In 2007 they also had the highest SGR in the industry which shows they have a greater growth potential than their competitors. This is due to them having a higher internal growth rate and choosing to have a higher debt/equity ratio. Stryker is also very consistent which should be a plus to investors. 89

90 Financial Statement Forecasting Forecasting financial statements is a good way to add value to a firm because it can provide an estimate of the future cash flows. Most estimates for performance are based on the sales forecast, but a thorough analysis was done on Stryker in order to try and discern a higher level of accuracy to their future performance. The financial statements are found in the 10-K reports. They are very useful in finding all the ratios and forecasts we have mentioned thus far. These statements are the foundation to forecasting the future performance of the company. To forecast a financial statement, the first and most critical step is to common size the financial statements. This allows us to analyze Stryker with percentages and make an easy comparison as opposed to comparing lots of large numbers. Once you common size all of the financial statements it makes it easy to compare all the rival firms within the medical technology industry. We then determined that we needed ten years of forecasted financial statement. To forecast the financial statements we utilized different growth rates, averages, as well as profitability and liquidity ratios. These allowed us to forecast a reliable number in assets or sales and work off of it to determine other line items within the financial statements. Income Statement The income statement is probably the most influential tool utilized to predict future cash flows within the organization. Investors analyze the income statement to understand where revenues are earned and expenses are incurred. We can forecast future sales, cost of goods sold, gross profit, and net income if we can understand the past transactions of the company. When looking to forecast the income statement we first computed a common sized statement to allow easier comparison between different years within the company. This was done by calculating every value within the statement as a percentage of total revenues (sales). The first item we looked to forecast was total revenues for the company which was basically sales. After figuring out which line items we could forecast and which ones we could not, we went with sales, cost of goods sold, gross profit, research and development, SGA expenses, purchased in-process research and development, operating expenses, operating 90

91 income, and finally net earnings. Our numbers showed that Stryker was improving its net earnings and sales at a very high rate (13% and 23%, respectively). Overall, the firm showed great improvements throughout their income statements and promise to be a very profitable company in the future. 91

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93 Income Statement Net sales Cost of sales Gross profit Research, development and engineering expenses Selling, general and administrative expenses Intangible asset amortization Intangible asset impairment Purchased in-process research and development Operating Expenses Operating income Other income (expense) Earnings from continuing operations before income taxes Income taxes Net earnings from continuing operations Net earnings from discontinued operations Net gain on sale of discontinued operations Net earnings Common Size Income Statement Net sales 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% Cost of sales 36% 35% 32% 31% 31% 30% 29% 28% 27% 26% 25% 24% 23% 22% 22% Gross profit 64% 65% 68% 69% 69% 69% 70% 70% 70% 70% 71% 71% 71% 72% 72% Research, development and engineering expenses 5% 5% 6% 6% 6% 7% 7% 7% 8% 8% 9% 9% 10% 11% 11% Selling, general and administrative expenses 39% 39% 40% 40% 40% 40% 40% 40% 41% 41% 41% 41% 41% 42% 42% Intangible asset amortization 1% 1% 1% 1% 1% Intangible asset impairment 0% 0% 0% 0% 0% Purchased in-process research and development 0% 3% 0% 1% 0% Operating Expenses 45% 48% 47% 48% 47% 48% 48% 49% 49% 50% 50% 51% 51% 52% 52% Operating income 19% 17% 20% 21% 22% 22% 23% 23% 24% 24% 25% 25% 26% 27% 27% Other income (expense) -1% 0% 0% 1% 1% Earnings from continuing operations before income taxes 18% 17% 20% 21% 23% Income taxes 5% 6% 7% 6% 6% Net earnings from continuing operations 0% 0% 14% 15% 16% Net earnings from discontinued operations 0% 0% 0% 0% 0% Net gain on sale of discontinued operations 0% 0% 0% 0% 0% Net earnings 13% 11% 14% 15% 17% 18% 18% 19% 20% 21% 21% 22% 23% 24% 25% 93

94 Balance Sheet The balance sheet is a list of all the assets a company has and how they are financed. The way they are financed can often be gathered from the income statement since net income flows directly into retained earnings in owner s equity. This was one way in which we forecasted Stryker for the next ten years in the balance sheet. Although we were able to use net income to forecast retained earnings, we had to use our common sized balance sheet to determine the other forecasts such as total assets. After preparing the common sized statement we looked at the growth between years and used this as a benchmark for future forecasts. The different financial statistics we forecasted were current, non-current, and total assets, current, long-term, and total liabilities, retained earnings, total equity and total liabilities and owner s equity. The first financial figure we forecasted was total assets by utilizing the common sized balance sheet. We analyzed the change in total assets over the past five years to determine an adequate growth rate. After determining the forecasted total assets for the next 10 years we examined the current assets percentage of total assets for the past five years. Many of the line items we could not forecast because no trend was apparent. The next area of the balance sheet we looked to forecast was retained earnings. Retained earnings was computed using year one s retained earnings and adding year two s net income found in the income statement. After analyzing and determining a comfortable estimate for net income in the next ten years we were then able to use this to forecast retained earnings for the next ten years. Owner s Equity was then found by mirroring retained earnings in the amount of growth from one year to the next. Therefore both retained earnings and owner s equity grow by the amount of net income generated in the current year. Unfortunately there is a flaw in this assumption due to the fact a company would not allow their retained earnings to grow to such a large amount over time. We decided upon a much more reasonable growth rate estimate, compared it to the ratios it created in our common size balance sheet and adjusted it to where it made sense. We then used owner s equity and total assets to find total liabilities by taking 94

95 total assets less total equity. Getting the balance sheet to balance after forecasting the future transactions and events was quite an undertaking. Many of our numbers did not make sense the first time. This may have flawed our forecast a little, but it has definitely made our predictions seem more reliable. To calculate current liabilities we used the current ratio by finding the average current ratio over the past five years. We threw out a couple years from the average because they did not match the trend. 95

96 Balance Sheet ASSETS Current Assets Cash and cash equivalents Marketable securities Accounts receivable, less allowance of $44.5 ($41.8 in 2006) Inventories Deferred income taxes Prepaid expenses and other current assets Current assets of discontinued operations Total current assets Property, Plant and Equipment Land, buildings and improvements Machinery and equipment Less allowance for depreciation Total Property, Plant and Equipment Other Assets Goodwill Other intangibles, less accumulated amortization of $356.2 ($281.7 in 2006) Loaner instrumentation, less accumulated amortization of $708.7 ($564.6 in 2006) Deferred income taxes Other Noncurrent assets of discontinued operations Total Other Assets Total Assets LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Accounts payable Accrued compensation Income taxes Dividend payable Accrued expenses and other liabilities Current maturities of long-term debt Current liabilities of discontinued operations Total current liabilities Long-Term Debt, Excluding Current Maturities Other Liabilities Other Liabilities of Discontinued Operations Total Long-Term Liabilities Total Liabilities Shareholders' Equity Common stock, $.10 par value: Authorized - 1,000.0 shares, Outstanding shares (407.9 in 2006) Additional paid-in capital Retained earnings Deferred stock-based compensation Accumulated other comprehensive gain Total shareholders' equity Total Liabilities and Shareholder's Equity

97 Common Size Balance Sheet ASSETS Current Assets Cash and cash equivalents 2% 9% 10% 7% 4% Marketable securities 0% 0% 11% 17% 29% Accounts receivable, less allowance of $44.5 ($41.8 in 2006) 16% 18% 16% 15% 14% Inventories 15% 14% 11% 12% 11% Deferred income taxes 10% 10% 8% 7% 7% Prepaid expenses and other current assets 2% 2% 2% 2% 2% Current assets of discontinued operations 0% 0% 0% 1% 0% Total current assets 44% 52% 58% 60% 67% 56% 56% 56% 56% 56% 56% 56% 56% 56% 56% Property, Plant and Equipment Land, buildings and improvements 13% 12% 11% 11% 9% Machinery and equipment 21% 18% 17% 16% 15% Less allowance for depreciation 15% 13% 12% 11% 11% Total Property, Plant and Equipment 19% 17% 17% 16% 13% Other Assets Goodwill 16% 12% 10% 9% 7% Other intangibles, less accumulated amortization of $356.2 ($281.7 in 2006) 15% 11% 8% 7% 5% Loaner instrumentation, less accumulated amortization of $708.7 ($564.6 in 2006) 4% 5% 5% 5% 4% Deferred income taxes 1% 1% 1% 2% 2% Other 1% 1% 1% 1% 1% Noncurrent assets of discontinued operations 0% 0% 0% 1% 0% Total Other Assets 37% 30% 25% 24% 20% 44% 44% 44% 44% 44% 44% 44% 44% 44% 44% Total Assets 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Accounts payable 4% 5% 4% 4% 4% Accrued compensation 7% 6% 5% 5% 4% Income taxes 0% 5% 4% 4% 1% Dividend payable 0% 0% 0% 2% 2% Accrued expenses and other liabilities 4% 11% 11% 8% 7% Current maturities of long-term debt 11% 0% 1% 0% 0% Current liabilities of discontinued operations 0% 0% 0% 0% 0% Total current liabilities 27% 27% 25% 23% 18% 24% 24% 24% 24% 24% 24% 24% 24% 24% 24% Long-Term Debt, Excluding Current Maturities 1% 0% 4% 0% 0% Other Liabilities 4% 5% 5% 6% 9% Other Liabilities of Discontinued Operations 0% 0% 0% 0% 0% Total Long-Term Liabilities 5% 5% 9% 6% 9% 7% 7% 7% 7% 7% 7% 7% 7% 7% 7% Total Liabilities 32% 33% 34% 29% 27% 31% 31% 31% 31% 31% 31% 31% 31% 31% 31% Shareholders' Equity Common stock, $.10 par value: 1% 0% 0% 0% 0% Authorized - 1,000.0 shares, Outstanding shares (407.9 in 2006) 5% 1% 1% 1% 1% Additional paid-in capital 59% 5% 6% 10% 10% Retained earnings 3% 56% 59% 59% 59% 59% 59% 59% 59% 59% 59% 59% 59% 59% 59% Deferred stock-based compensation 0% 0% 0% 0% 0% Accumulated other comprehensive gain 0% 5% 0% 2% 4% Total shareholders' equity 68% 67% 66% 71% 73% 70% 68% 66% 64% 63% 62% 62% 61% 61% 60% Total Liabilities and Shareholder's Equity 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% ASSET TURNOVER RATIO Average ATO Forecasted ATO

98 Cash Flows The cash flows statement is a very important component in financial statements since it shows where the money is changing hands. This statement provides a better understanding of the flow of cash from operating, investing, and financing activities. To forecast the operating cash flows we analyzed the Cash Flows from Operations/ Sales (CFFO/Sales), Cash Flows from Operations/ Net Income (CFFO/NI), and Cash Flows from Operations/ Operating Income (CFFO/OI). We looked for a trend in these ratio s and determined CFFO/Sales was our best estimate for forecasting cash flows from operations. We took the calculations performed for CFFO/ Sales and averaged the past five years to find an average ratio of 13.65%. We then took sales from 2007 and multiplied them by this ratio to find cash flow from operations in This trend was continued for the next 9 years to forecast cash flows from operations. Then we used the change in long term assets to forecast cash flows from investing activities. This method can be used because as long term assets increase, cash is being used to purchase these items. This means there is always cash moving into these assets, thus a sustainable and constant cash flow. As these assets decrease cash is being received from the sale of these assets therefore leading to positive cash inflow from investing activity. We left out the financing activities forecast because no trend for growth could be found from the data we found. 98

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100 Cash Flows Operating Activities Net earnings Less: Net earnings from discontinued operations Less: Net gain on sale of discontinued operations Net earnings from continuing operations Adjustments to reconcile net earnings from continuing operations to net cash provided by operating activities: Depreciation Amortization Share-based compensation Income tax benefit from exercise of stock options Excess income tax benefit from exercise of stock options Intangible asset impairment Purchased in-process research and development Restructuring and acquisition-related items Payments of restructuring and acquisition-related liabilities Provision for losses on accounts receivable Deferred income tax expense (credit) Other Changes in operating assets and liabilities, net of effects of acquisitions: Proceeds from (reductions of) accounts receivable securitization Accounts receivable Inventories Loaner instrumentation Accounts payable Payments of acquisition purchase liabilities Accrued expenses and other liabilities Income taxes Other Net cash provided by (used in) discontinued operations Net cash provided by operating activities Investing Activities Acquisitions, net of cash acquired Proceeds from sale of discontinued operations, net of cash divested Purchases of marketable securities *the number used for 'net cash used in investing activities' in 2007 ( ) Proceeds from sales of marketable securities was replaced with a predicted number from 2006 because it was a rogue number Purchases of property, plant and equipment that did not fit the trend. Proceeds from sales of property, plant and equipment Net cash used by discontinued operations Net cash used in investing activities Financing Activities Proceeds from borrowings Payments on borrowings Dividends paid Proceeds from exercise of stock options Excess income tax benefit from exercise of stock options * dividends grew at 11 cents per share every year Other Net cash provided by (used in) financing activities Effect of exchange rate changes on cash and cash equivalents Increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year

101 Common Size Statement of Cash Flows Operating Activities Net earnings 70% 78% 77% 90% 99% Less: Net earnings from discontinued operations 0% 0% -1% -1% 0% Less: Net gain on sale of discontinued operations 0% 0% 0% 0% -2% Net earnings from continuing operations 70% 78% 76% 89% 96% Adjustments to reconcile net earnings from continuing operations to net cash provided by operating activities: Depreciation 15% 17% 12% 13% 13% Amortization 20% 25% 22% 24% 22% Share-based compensation 0% 0% 6% 7% 6% Income tax benefit from exercise of stock options 6% 7% 4% 4% 5% Excess income tax benefit from exercise of stock options 0% 0% -4% -3% -4% Intangible asset impairment 0% 0% 0% 0% 2% Purchased in-process research and development 0% 20% 2% 6% 0% Restructuring and acquisition-related items Payments of restructuring and acquisition-related -2% -1% 0% 0% 0% liabilities 0% 0% 0% 0% 0% Provision for losses on accounts receivable 2% 3% 1% 0% 1% Deferred income tax expense (credit) -5% -11% 1% -3% -14% Other 1% 2% 1% 1% 1% Changes in operating assets and liabilities, net of effects of acquisitions: Proceeds from (reductions of) accounts receivable securitization 3% -25% 0% 0% 0% Accounts receivable -12% -16% -8% -12% -13% Inventories -1% -11% -5% -10% -9% Loaner instrumentation -14% -27% -23% -23% -18% Accounts payable 4% 12% 0% 5% 1% Payments of acquisition purchase liabilities Accrued expenses and other liabilities 12% 23% 9% 3% 2% Income taxes 1% 7% 2% -1% 8% Other 0% -4% 1% -1% 2% Net cash provided by (used in) discontinued operations 0% 0% 3% 2% -1% Net cash provided by operating activities 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% Investing Activities Acquisitions, net of cash acquired 7% 45% 6% 13% 6% Proceeds from sale of discontinued operations, net of cash divested 0% 0% 0% 0% -16% Purchases of marketable securities 0% 0% 171% 1231% 1661% Proceeds from sales of marketable securities 0% 0% -107% -1173% -1540% Purchases of property, plant and equipment 95% 58% 29% 28% 21% Proceeds from sales of property, plant and equipment -2% -3% 0% 0% 0% Net cash used by discontinued operations 0% 0% 1% 2% 0% Net cash used in investing activities 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% Financing Activities (done as percentage of net earnings) Proceeds from borrowings 147% 116% 91% 15% 10% Payments on borrowings -252% -119% -57% -44% -10% Dividends paid -6% -8% -7% -12% 13% 15% 16% 16% 16% 16% 15% 14% 13% 12% 11% Proceeds from exercise of stock options 6% 8% 5% 6% 7% Excess income tax benefit from exercise of stock options 0% 0% 5% 3% 4% Other 0% 4% -2% -1% -1% Net cash provided by (used in) financing activities -105% 2% 36% -26% 1% Effect of exchange rate changes on cash and cash equivalents 2% 1% -3% 0% 1% Increase (decrease) in cash and cash equivalents 6% 61% 22% -10% -12% 101 Cash and cash equivalents at beginning of year 8% 14% 54% 63% 41% Cash and cash equivalents at end of year 15% 75% 76% 54% 29%

102 Cost of Capital Estimation Estimating the cost of capital is a very important aspect of evaluating a firm. To find the cost of capital we took the weighted average of the cost of debt and the cost of equity which gives us the weighted average cost of capital, or WACC. The WACC is the overall required return on the firm as a whole and is used by company directors in deciding when and when not to except expansionary projects. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm (Investipedia.com). Cost of Equity Cost of capital cannot be computed without first finding the cost of equity. We used the CAPM model to estimate Stryker s cost of equity. To do so, we had to first use information found on the St. Louis Federal Reserve s website to find the risk free rates of the three month, six month, two year, five year and ten year treasury bills. Treasury bills are considered to have risk free rates. These annual rates were then converted into their monthly form and then into decimal form. We also found the prices for the S&P 500 in order to find a market rate of return. After studying the risk free rates, we then estimated Stryker s market risk premium to be 7.00%. Beta, which is used to measure risk, was then calculated after running a series of regressions. Regressions for each of the treasury bills was run over a 24 month, 36 month, 48 month, 60 month and 72 month time frame. We took the interest rates of Treasury Bills from five different time periods and ran them over 5 different horizons to help us determine the stability of beta over time and to help us determine how long investors prefer to hold Stryker s stock. It is important to determine the stability of Stryker s beta because beta is a measure of risk. Our beta was chosen after finding the highest adjusted R^2. We found the highest R^2 to be 0.18, or 18.10% as found under the five year, 36 month 14

103 regression. The corresponding Beta was We also used a risk free rate of 2.50% and a market risk premium of 7.00% for that five year regression model. Cost of equity can then be computed as follows: CAPM Model: Ke = RF + beta (Market Risk Premium) Ke = 2.50% (7.00%)=11.31% As the firm s R^2 was higher than 10%, it is unnecessary to calculate Stryker s cost of equity using the backdoor method. Cost of Debt The cost of debt represents the interest rate for a firm s current and long term debt. To calculate Stryker s cost of debt we used two different interest rates found in Stryker s 10-k. The interest rate Stryker owes on short term debt is 5.3%. We multiplied this number by the amount of short term debt Stryker has divided by their total debt. We then took the rate of 4.4% that the Company owes on their defined benefit pension plans, which accounts for all of their long term debt, and multiplied it by the amount of long term debt divided by total debt. The weighted average of these two interest rates comes out to be 5.01% which is the before tax cost of debt. When that number is divided by the corporate tax rate of 35 percent, you get an after tax cost of debt of 3.26%. ( / ) * (.053) =.0358 (642500/ ) * (.044) = =.0501 or 5.01% Before Tax (.0501) * (1-.35) =.0326 or 3.26% After Tax 103

104 Regression Analysis 24 months 36 months 48 months 60 months 72 months 24 months 36 months 48 months 60 months 72 months 24 months 36 months 48 months 60 months 72 months Stryker Corporation Beta 3 month 6 month 2 year 5 year 10 year Adjusted R^2 3 month 6 month 2 year 5 year 10 year t stat 3 month 6 month 2 year 5 year 10 year P value 3 month 6 month 2 year 5 year 10 year 104

105 24 months 36 months 48 months 60 months 72 months 24 months 36 months 48 months 60 months 72 months 24 months 36 months 48 months 60 months 72 months Ke 3 month 6 month 2 year 5 year 10 year 7.51% 7.65% 7.90% 8.65% 9.64% 10.17% 10.32% 10.58% 11.31% 12.29% 8.65% 8.82% 9.19% 10.03% 11.07% 7.21% 7.36% 7.70% 8.54% 9.58% 5.23% 5.38% 5.66% 6.43% 7.44% Risk Free Rate 3 month 6 month 2 year 5 year 10 year 1.37% 1.51% 1.75% 2.50% 3.50% 1.37% 1.51% 1.75% 2.50% 3.50% 1.37% 1.51% 1.75% 2.50% 3.50% 1.37% 1.51% 1.75% 2.50% 3.50% 1.37% 1.51% 1.75% 2.50% 3.50% 105

106 Weighted Average Cost of Capital WACC consists of weighting the cost of debt and cost of equity depending on their market values. The formula for WACC is: WACC = Vd [Rd(1-T)] + Ve (Ke) Vd + Ve Ve + Vd The book value of debt (Vd) is $ million. The market value of equity (Ve) is $26620 million. Their cost of debt (Rd) was 5.01%. T is the tax rate of 35% and Ke is the cost of equity, which we found to be 11.31% by using the CAPM model r^2=18.1%. WACC= /( ) *(.0501(1-.35)) /( ) * (.1131) We then found the WACC for Stryker to be equal to 10.75%. 106

107 Equity Valuations In determining the value of a firm, analyst must take into consideration two different types of comparables: the method of comparables ratios and the intrinsic valuation models. The method of comparables uses ratios to compare a firm s equity to that of the other major competitors in the industry. These models give investors a quick way to determine the value of equity for the company. Intrinsic valuations require larger amounts of financial data in order to determine the whether the share price for the firm is correctly valued. It is much more in depth than the method of comparables. That said, the method of comparables is the weaker basis for valuing a firm. The intrinsic valuation models will, therefore, be more heavily weighted. Method of Comparables The method of comparables is used to evaluate a firm relative to the industry and market averages. This allows investors to see how Stryker s share price is relative to its competitors. An issue occurred with one of Stryker s competitors that would have left the industry averages inadequate. Biomet, a competitor used throughout the evaluation, is a privately held company with no public information available except for its 10-K. Without detailed information that is only obtainable from sites like Yahoo Finance, the results were inconclusive. In order to calculate the most accurate industry averages, there was a need for another competitor. In its place for these models, Medtronic (a medical appliances and equipment company that specializes in cardiac devices and spinal segments) is a direct competitor according to Yahoo Finance and will improve the industry averages in order to have a more accurate comparable price of Stryker. Below are the findings for each model with the suggested price. 107

108 Model Suggested Price Compared to Actual Price P/E Trailing Undervalued P/E Forward Fairly Valued P/B Fairly Valued P.E.G Fairly Valued P/EBITDA Slightly Overvalued P/FCF Undervalued EV/EBITDA Fairly Valued Observed Share Price April 1-Valuation Date Price to Earnings Trailing P/E Trailing Comparable Company PPS EPS P/E Trailing Industry Avg. P/E SYK PPS Stryker Smith & Nephew Zimmer Biomet Medtronic The chart given above shows the trailing price to earnings ratios for Stryker, Stryker s competitors and the industry s average. The price per share and earnings per share were all found through Yahoo Finance. To find the P/E trailing price, each company s PPS was then divided by their EPS. The industry average P/E was calculated by averaging the competitors not including Stryker because this would add unwanted weight to the average. The industry average P/E was then multiplied by Stryker s EPS to indicate the comparable Stryker PPS. 108

109 When comparing Stryker s PPS of to the comparable PPS of , it was determined that the price per share is undervalued. Price to Earnings Forward P/E Forward Comparable Company PPS EPS 1 yr Out P/E Forecast Industry Avg. P/E SYK PPS Stryker Smith & Nephew Zimmer Biomet Medtronic The chart above shows the Forward Price to Earnings Ratio to compare Stryker to its competitors. The industry average P/E and Comparable PPS are found using forecasted numbers and an EPS one year out. After finding the industry average P/E of Stryker s competitors, the comparable PPS is calculated by multiplying this by the EPS one year out. When comparing (comparable Stryker PPS) to Stryker s PPS of it is fairly valued due to the 20% error tolerance. The forward price to earnings ratio is a good indicator of Stryker s forecasted P/E and EPS proving that the estimations of Stryker are accurate. Even though Stryker is fairly valued for this model, it is important to keep in mind that this method only values firms in the short run and it is necessary to evaluate other models equally. 109

110 Price to Book Value Ratio P/B Comparable Company PPS BPS P/B Industry Avg. P/B SYK PPS Stryker Smith & Nephew Zimmer Biomet Medtronic The price to book ratio is a model that is important to consider in the valuation of a company in that it compares the company s value to the book value of equity. To calculate the comparable PPS, price per share is divided by the book value per share to find the price to book ratio. Once again, the industry average P/B is calculated by averaging Stryker s competitors. The final step is to take the industry average of P/B and multiply it by Stryker s BPS. Stryker s PPS is and measured up to the comparable industry PPS; it is determinable that Stryker is fairly valued. Price Earnings Growth (PEG) P.E.G Comparable Company PE EGR t+1 P.E.G. Industry Avg. SYK PPS Stryker Smith & Nephew Zimmer Biomet Medtronic

111 The Excel table above shows the Price Earnings Growth numbers for Stryker and its competitors. The Price Earnings Growth (PEG) ratio can be calculated by taking a company s P/E ratio and dividing it by a company s expected growth rate. The industry average of 1.44 is then multiplied by Stryker s estimated earnings growth rate of 19.1%. This number was then multiplied by 100 to give Stryker a comparable price of $ This demonstrates that Stryker is fairly valued according to this model. Price to EBITDA P/EBITDA Comparable Company Market Cap($Bill) EBITDA($Bill) P/EBITDA Industry Avg. SYK PPS Stryker Smith & Nephew Zimmer Biomet Medtronic Above is the table listing all of Stryker and its competitors Price to EBITDA ratios. Since both numbers are listed in billions, this simplified the calculations considerably. This model can be used to determine a valuation of Stryker s share price by taking the industry average (12.29) and multiplying it by Stryker s EBITDA (1.69). This gave a per share price of $ This means that Stryker is slightly overvalued. 111

112 Price to Free Cash Flows P/FCF Comparable Company Market Cap($Bill) FCF($Bill) P/FCF Industry Avg. SYK PPS Stryker Smith & Nephew Zimmer Biomet Medtronic The chart above lists the Price to Free Cash Flow ratios for Stryker and its competitors. Free cash flows for a company are determined by taking cash from operating activities and adding/subtracting increases or decreases in the company s investing activities. With the Market Cap given on Yahoo Finance, it is divided by the free cash flow ratio to find all the ratios for Stryker and its competitors. The results varied greatly, yet an industry average of was found, which was then used to find a per share price for Stryker of $ This method does not seem very reliable, so saying that Stryker is undervalued according to this model holds very little credibility. Enterprise Value to EBITDA Enterprise Value/EBITDA Comparable Company EV EBITDA($Bill) EV/EBITDA Industry Avg. SYK PPS Stryker Smith & Nephew Zimmer Biomet

113 Medtronic The table shown above is the assortment of Enterprise to EBITDA ratios for Stryker, its competitors, and the industry average. It was crucial to find each of our competitor s Enterprise Value to EBITDA numbers in order to calculate Stryker s share price. Yahoo Finance was used to find these values and assembled them to make it easier to compare each of the companies and find the industry average of The industry average of EV/EBITDA was then multiplied by Stryker s EBITDA which gave an enterprise value per share price of $ This method indicates that Stryker s price is fairly valued, since it is within the 20% error tolerance of the actual price. Conclusion The method of comparables model for Stryker has been inconclusive. With results ranging from undervalued to overvalued, it is unclear as to the status of the firm. There is theme of fairly valued for the price per share of $65.85 that includes price to earnings forward, price to book value ratio, price earnings growth, and enterprise value to EBITDA. Yet, with the trailing price to earnings and price to free cash flows being undervalued along with price to EBITDA being slightly overvalued, the majority cannot be the only evaluation decision. To make an informed and educated decision about the evaluation and analysis of Stryker, intrinsic models must be calculated and weighted along with the method of comparables. 113

114 Intrinsic Valuations Intrinsic valuation models are utilized in order to accurately value the firm. These models are more accurate than the Method of Comparables as they are much more extensive in that they use more financial data for the firm in question. The five intrinsic models used in the analysis of Stryker Corporation include: The Discounted Dividends Model, Free Cash Flow Model, Residual Income Model (RI), Long Run Residual Income Model, and the Abnormal Earnings Growth Model (AEG). Following those models is their respective sensitivity analysis, or the change seen in the price of Stryker stock when the growth rate changes. It can then be estimated as to whether the firm is over, under, or accurately valued. Free Cash Flows Model The free cash flow model determines the firm s equity by determining the present value of future cash flows to be generated by the firm. Generally, this model has more explanatory power than the Discount Dividends Model, but it is still very sensitive to changes in the terminal growth rates. The company s free cash flows can be calculated used the following formula: Free Cash Flow = CFFO Activities +/- CFFI Activities According to this formula, a firm s Free Cash Flows is a measure of financial performance calculated as operating cash flow minus capital expenditures (Cash Flow From Investing Activities). Free Cash Flow is a representation of the cash that a firm is able to generate after putting forth the money required to maintain or expand their asset base (keep operating or expand the business). Free Cash Flow is an important measurement for firms because it allows them to pursue opportunities that enhance shareholder value. Without cash, it is hard to develop new products, make acquisitions, pay out dividends and, most importantly, reduce debt. 114

115 Once the Free Cash Flow is determined, it can be plugged into the model to determine the firm s Market Value of Equity. The formula for that model is: To use this model, it is easier to break it down into sections. First, we forecasted Stryker s free cash flows (shown in the formula as FCF(t)) and discounted them back to the present using a present value factor:. This is done with the same formula used in the Discount Dividends Model, but instead of using Stryker s cost of equity (k e ) their WACC BT is used in our calculations of each year s present value factor. Each year s free cash flow values were then divided by their respective present value factors to give us the annual present value of free cash flows. Summing the annual present value of free cash flows gave us a total present value of free cash flows of $5, million. The perpetuity of future terminal cash flows and its present value was then calculated using the following equations: Continuous TV Perpetuity = g is the FCF terminal growth rate (what I got) $93,016.49= /( ) Reading the formula closely, you will realize that this valuation is only summing ten years of cash flows values, and the eleventh year s FCF is forecasted for the sake of finding the perpetuity. This does not have to be a valuation for ten years, so long as the periods are adjusted in the formula accordingly. PV of Terminal Perpetuity = Continuous TV Perpetuity x PV Factor 10 The PV Factor 10 = 1/(1+ WACC BT ) 10, or:... which gives us $33,506 = 93, x [1/( ) 10 ] 115

116 The total company value of Stryker was determined to be $39, million by summing all the present values of forecasted annual free cash flows and the present value of the perpetuity. Since Stryker s Book Value of Debt (BV D ) is $1,976 million, we simply subtracted this value from our calculated firm value of $39, million to get the Company s market value of equity on 12/31/07 of $37, million. The market value of equity was then divided by Stryker s million shares outstanding to get a 12/31/07 share price of $ This value was then converted into a 5/01/08 share price by multiplying it by one plus the WACC BT raised to the remaining 4 months over 12. Below is an illustration of our calculations. 12/31/07 PPS= VF BVE or $39, $1,976 = $37,504.62/ = $ /01/08 PPS = 91.16*(( ) ^ (4/12)) = $94.37 The formulas above indicate that Stryker has an estimated share price of $91.21 on 12/31/07 and an implied share price of $94.37 at 5/01/08. Since Stryker had an observed share price of $65.68 on 5/01/08, this indicates to analysts and investors that Stryker s share price is undervalued using the Discounted Free Cash Flow Model. Sensitivity Analysis WACC Growth Rates

117 The above chart is the sensitivity analysis for Stryker using the Free Cash Flow valuation model. This shows the resultant share prices when Stryker s WACC BT values and free cash flow growth rates fluctuate. The share prices that this analysis generated show ample amounts of volatility. For example, at Stryker s current free cash flow growth rate of 6%, the share price declines by $58.11 as the WACC BT is increased from 8.75% to 9.75%. Such a large reaction to a 1% increase in one variable shows that this model is very sensitive and holds a rather unbalanced emphasis on the variation of two factors. The chart also shows that as the WACC BT decreases (increases) and the growth rate increases (decreases), the share price also increases (decreases). Residual Income Model The Residual Income Model is another intrinsic valuation method that can be used by analyst and investors. The residual income model is one of the safest models of valuation of a firm s equity as it is less sensitive to the estimated terminal value than the other models. It is also considered to be one of the best models for valuation because it can be used to value stocks that do not have stable dividends or cash flows. The Residual Income Model requires the book value of equity, the forecasted earnings, the forecasted dividends, cost of equity, and the growth rate of residual income which is a negative growth. To find the intrinsic share price of Stryker s stock, we had to calculate the residual income and then discount back the residual income numbers to the present. To find residual income, the first thing we had to do was to find the book value of equity for each of our 10 years by taking the ending book value of equity for the previous year, adding the earnings and subtracting the dividends of the year you want to find. We then had to find the benchmark income which is found by taking the book value of equity found for the previous year and multiplying it by the cost of equity of 11.31%. Upon finding the normal(benchmark) income for each of the 117

118 10 years we then subtracted these numbers from the same years forecasted earnings to get the residual income. These formulas are as follows: Normal(benchmark) Income = BVEt-1 x Cost of Equity Residual Income = Earnings - Normal Income Perp Annual Residual Income Annual Change in Residual Income Once we have all the residual income for the 10 years we then discounted them back to the present by multiplying them by their respective present value factors we used in the previous models. We then added these numbers up to get the total PV of the year by year residual income which came out to be $6, million. Last, we calculated the continuous terminal value perpetuity and its present value which came out to be $ million. The formulas below show our calculations. Continuous TV Perpetuity = RIyr 11/ (Ke RI growth rate) $ = $ / ( ) PV of Terminal Perpetuity = Cont. TV Perpetuity x PV Factoryr 10 $ = $ x Now that we had the present value of the terminal perpetuity and the present value of the year by year residual income we added these numbers to the book value at 12/31/07 to get the Market value of Equity. We then divided the MVe by the number of shares outstanding to get the price per share as of 12/31/2007. This number was then multiplied by 1 plus the cost of equity to the 3/12 s power to get the share price as of 4/1/ /31/07 PPS = ( , )/ shares= $ /1/07 PPS= 40.89*( )^3/12= $

119 Our time consistent share price of $42 is below the observed share price of $65.85 on April 1 st 2008, which tells us that Stryker is overvalued. Sensitivity Analysis Ke Growth Rates upper bounds lower bounds As you can tell from the table above with a Ke of.1131 and a growth rate of -10 percent Stryker is slightly overvalued. It is also important to notice that there is very little volatility when changing the growth rates which is why the residual income model is considered one of the most accurate measures of a firm s equity. Long Run Return on Equity Residual Income Model The Long Run Residual Income Model is used to calculate a firm s value of equity by using information in the above Residual Income Model. This model is used by analysts and investors in their determination of the present value of a firm s equity using long run equity growth rates, long run return on equity estimates, forecasted book value of equity, and the firm s cost of equity. These statistics are placed into a perpetuity formula to find the present value of a company s equity. In the equity valuation of Stryker using the Long Run Return on Equity Residual Income Model, the first step taken was determining the forecasted book value of equity. We forecasted our book value of equity to be $5,378.5 million using the following formula in our Residual Income Model: 119

120 After we found Stryker s forecasted book value of equity, we then computed Stryker s long run return on equity (ROE) and equity growth rate figures. These estimates were done using the following formulas: ROE Values Equity Growth Rates The diagrams above show Stryker s long run Return on Equity (ROE) and Equity growth rates over a ten year period. In each subsequent period, Equity growth showed a minor decline. However, ROE held steady between 21.8% and 22.3%. The decline in Equity growth is ordinary for companies like Stryker that experience above average ROE and growth rates. In the long run the growth of equity and return on equity should return to normal industry standards. In our equity valuation, we concluded that Stryker s long run ROE is 24.64% and their Equity growth rate is 8%. We inserted the information we gathered for Stryker into the following formula to determine the present value of the firm s equity. Using this perpetuity formula, we estimated the value of the firm to be $27, million at the end of December Dividing the value of the firm by the million shares outstanding gave us a share price for Stryker of $65.76 on December 31, Converting this price to an April 1, 2008 price 120

121 gave us a share price for Stryker of $ This indicates that Kroger s observed share price of $65.68 is fairly priced using the Long Run Return on Equity Residual Income Model. Below is a sensitivity analysis for Stryker using this valuation model. Sensitivity Analysis Growth Rates Ke=11.31% ROE ROE g=8.00% Ke Growth Rates ROE=24.64% Ke upper bounds undervalued lower bounds overvalued 121

122 Observed Share Price = $65.68 The above charts are sensitivity analyses for the Long Run Return on Equity Residual Income Model for Stryker. In this sensitivity analysis, we used three different variables to evaluate the fluctuations in share prices: long run ROE, long run Equity growth rate, and the company s cost of equity. It is interesting to note that Stryker s share price is fairly valued if the cost of equity (Ke) is kept constant at 11.31% and Stryker s ROE is placed at 24.64%. As the ROE decreases and the growth rate increases, the share price also increases and eventually the prices start to vary by such larger increments that it makes it hard to get a fair share price. However, even with this incongruity, the model shows that Stryker is fairly priced. Abnormal Earnings Growth (AEG) Model The abnormal earnings growth model determines the current market value of a company s equity and is based on the theory of a forward price to earnings ratio. The AEG model is the second most accurate model to determine the firms value after the residual income model because it is less sensitive to the cost of capital and growth rates. To calculate the abnormal earnings, we used net income from the forecasting done previously. To then determine the benchmark earnings we took the previous year s earnings and multiplied it by 1 minus the cost of equity. The abnormal earnings were found by subtracting the benchmark earnings from the forecasted earnings. As a check and to show the intertwining between the AEG model and the Residual Income model, the annual AEG and the annual change in residual income should equal the same amount as shown below. AEG Check Period 1 Period 2 Period 3 Period 4 Period 5 Period 6 Period 7 Period 8 Period 9 Annual AEG Annual change in residual income

123 The relation between the AEG model and the RI model are what make these two models the most accurate of the five. With this type of checks and balances system, error due to misconstrued calculations is not a factor in the results of the model. The next step in the model is to find the terminal value by the present value factor. To get the present value of the abnormal earnings, the present value of the abnormal earnings and terminal values were added together. In adding the PV of the abnormal earnings with the core earnings, we can calculate the total average earnings for Stryker. The last step in the AEG model is to find the intrinsic value by taking the total earnings perpetuity (t+1) and dividing it by cost of equity. Once the intrinsic value is found, we divided it by the total shares outstanding to determine the time consistent price of $ The table below shows that Stryker is fairly valued for the Abnormal Earnings Growth Model. Ke Growth Rate Discount Dividends Model The discounted dividends model helps in determining the value of a firm by discounting the firm s future dividends back to the current time period. This is important to investors because according to this model the price they should pay for a share of stock is the expected future dividends discounted back to the present. Though the discounted dividends model is a better tool to use than the method of comparables, it has its flaws. Although the discount dividend model is more straightforward than the other intrinsic evaluations, certain inconsistencies can develop. First, the dividend discount model assumes companies will have an 123

124 infinite life span. Due to the various risks business face this assumption is not likely. It is also very difficult to forecasts dividends and to do so requires enormous amounts of speculation. Last, the discount dividends model is very sensitive to changes in growth rates which makes it less useful than the residual income or AEG models. In our equity valuation of Stryker using the discounted dividends model, we took our forecasted future dividends growing at.11 cents per year and discounted them back to now by dividing them by their respective present value factors. Our forecasted dividends start with actual dividends of.33 in 2007 and go through 1.54 in The present factors can be calculated by dividing 1 by 1 plus cost of equity to the power of years removed. Present value factor= 1/(1+Ke)^number of years out from current year. Once we had the present value of the future dividends we added them together to get the total present value of year by year dividends which came out to be $4.88. We then added this number to the continuing value perpetuity which can be calculated as follows: Continuing value perpetuity= 2018 forecasted dividend/( Ke-g) 46.53=1.54/( ) As we earlier mentioned, Stryker has a cost of equity of and we used a growth rate for our dividends of 8%. The $1.54 is our forecasted dividend per share in Once we get we have to discount it back to now /(1.1131)^10 = $15.93 We then add this which is the present value of the year by year dividends to get $20.81 which is the share price at the end of We then multiply this by ( )^3/12 to get a time consistent price of in 124

125 April, The observed share price for April, is $65.85 at it can be concluded that our share price is overvalued. ke Growth Rate upper bounds >undervalued lower bounds <overvalued Sensitivity Analysis The chart above is Stryker s sensitivity analysis using the discounted dividends model. As you can tell from this table Stryker s observed share price is overvalued for all of the combinations of Ke and growth rate except one. It is also important to notice how sensitive the numbers are to changes in growth rate which is an estimate. This is one reason the discounted dividends model is not as valid as the following models. Conclusion After completion of the five intrinsic valuation models, it can be concluded that Stryker s share price of $65.80 on April 1, 2008, is fairly valued. This determination is based largely on the intrinsic valuation models, but the method of comparables also found that; overall, Stryker is a fairly valued firm. As Stryker s current share price is fairly valued, any stock already owned should continue to be held. 125

126 Appendices Liquidity Ratios Current Ratio Stryker Zimmer Smith & Nephew Biomet Quick Asset Ratio Stryker Zimmer Smith & Nephew Biomet A/R Turnover Stryker Zimmer Smith & Nephew Biomet A/R Days Stryker Zimmer Smith & Nephew Biomet Inventory Turnover Stryker Zimmer Smith & Nephew Biomet

127 Inventory Days Stryker Zimmer Smith & Nephew Biomet Working Capital Turnover Stryker Zimmer Smith & Nephew Biomet Probability Ratios Gross Profit Margin Stryker Zimmer Smith & Nephew Biomet Operating Profit Margin Stryker Zimmer Smith & Nephew Biomet Net Profit Margin Stryker Zimmer Smith & Nephew Biomet

128 Asset Turnover Stryker Zimmer Smith & Nephew Biomet ROA Stryker Zimmer Smith & Nephew Biomet ROE Stryker Zimmer Smith & Nephew Biomet Capital Structure Debt/Equity Stryker Zimmer Smith & Nephew Biomet Time Interest Earned Stryker Zimmer Smith & Nephew Biomet

129 Debt Service Margin Stryker Zimmer Smith & Nephew Biomet Cash to Cash Cycle Stryker Zimmer Smith & Nephew Biomet IGR/SGR Internal Growth Rate Stryker Zimmer Smith & Nephew Biomet Sustainable Growth Rate Stryker Zimmer Smith & Nephew Biomet

130 Credit Risk Altman Z Score WC/TA RE/TA EBIT/TA Close Shares Outstanding MVE BVL Mve/BVI Sales/TA Z-Score NWC TA RE EBIT MVE BVL Sales NWC TA RE EBIT MVE BVL Sales NWC TA RE EBIT MVE BVL Sales NWC TA RE EBIT MVE BVL Sales NWC TA RE EBIT MVE BVL Sales

131 Weighted Average Cost of Equity 3 Month SUMMARY OUTPUT 3 month Beta Adj R^2 t st at p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 72 ANOVA df SS MS F Significance F Regression Residual Total Coeff icient standard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable SUMMARY OUTPUT Beta Adj R^2 t st at p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 60 ANOVA df SS MS F Significance F Regression Residual Total Coeff icient standard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable SUMMARY OUTPUTE OUTPUT Beta Adj R^2 t st at p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 48 ANOVA df SS MS F Significance F Regression Residual Total Coeff icient standard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable

132 SUMMARY OUTPUT Beta Adj R^2 t st at p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 36 ANOVA df SS MS F Significance F Regression Residual Total Coeff icient standard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable SUMMARY OUTPUT Beta Adj R^2 t st at p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 24 ANOVA df SS MS F Significance F Regression Residual Total Coeff icient standard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable Weighted Average Cost of Equity 6 Month 132

133 SUMMARY OUTPUT Beta Adj R^2 t stat p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 72 ANOVA df SS MS F Significance F Regression Residual Total

134 Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable SUM M ARY OUTPUT Beta Adj R^2 t stat p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 60 ANOVA df SS MS F Significance F Regression Residual Total Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable SUM M ARY OUTPUT Beta Adj R^2 t stat p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 48 ANOVA df SS MS F Significance F Regression Residual Total Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable

135 SUM M ARY OUTPUT Beta Adj R^2 t stat p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 36 ANOVA df SS MS F Significance F Regression Residual Total Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable SUM M ARY OUTPUT Beta Adj R^2 t stat p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 24 ANOVA df SS MS F Significance F Regression Residual Total Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable

136 Weighted Average Cost of Equity 2 Year SUM M ARY OUTPUT Beta Adj R^2 t st at p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 72 ANOVA df SS MS F Significance F Regression Residual Total Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable SUM M ARY OUTPUT Beta Adj R^2 t st at p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 60 ANOVA df SS MS F Significance F Regression Residual Total Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable SUMMARY OUTPUT Beta Adj R^2 t stat p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 48 ANOVA df SS MS F Significance F Regression Residual Total

137 Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable SUM M ARY OUTPUT Beta Adj R^2 t stat p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 36 ANOVA df SS MS F Significance F Regression Residual Total Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable SUM M ARY OUTPUT Beta Adj R^2 t stat p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 24 ANOVA df SS MS F Significance F Regression Residual Total Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable

138 Weighted Average Cost of Equity 5 Year SUMMARY OUTPUT Beta Adj R^2 t stat p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 72 ANOVA df SS MS F Significance F Regression Residual Total Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable SUMMARY OUTPUT Beta Adj R^2 t stat p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 60 ANOVA df SS MS F Significance F Regression Residual Total Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable SUMMARY OUTPUT Beta Adj R^2 t stat p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 48 ANOVA df SS MS F Significance F Regression Residual Total

139 Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable SUMMARY OUTPUT Beta Adj R^2 t stat p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 36 ANOVA df SS MS F Significance F Regression Residual Total Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable SUMMARY OUTPUT Beta Adj R^2 t stat p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 24 ANOVA df SS MS F Significance F Regression Residual Total Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable

140 Weighted Average Cost of Equity 10 Year SUM M ARY OUTPUT Beta Adj R^2 t stat p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 72 ANOVA df SS MS F Significance F Regression Residual Total Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable SUM M ARY OUTPUT Beta Adj R^2 t stat p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 60 ANOVA df SS MS F Significance F Regression Residual Total Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable SUM M ARY OUTPUT Beta Adj R^2 t stat p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 48 ANOVA df SS MS F Significance F Regression Residual Total

141 Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept 8.79E X Variable SUMMARY OUTPUT Beta Adj R^2 t stat p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 36 ANOVA df SS MS F Significance F Regression Residual Total Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable SUMMARY OUTPUT Beta Adj R^2 t stat p-value ke Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 24 ANOVA df SS MS F Significance F Regression Residual Total Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0% Intercept X Variable

142 Method of Comparables P/E Trailing Comparable Company PPS EPS P/E Trailing Industry Avg. P/E SYK PPS Stryker Smith & Nephew Zimmer Biomet Medtronic P/E Forward Company PPS EPS 1 yr Out P/E Forecast Industry Avg. P/E Comparable SYK PPS Stryker Smith & Nephew Zimmer Biomet Medtronic P/B Comparable Company PPS BPS P/B Industry Avg. P/B SYK PPS Stryker Smith & Nephew Zimmer Biomet Medtronic P.E.G Comparable Company PE EGR t+1 P.E.G. Industry Avg. SYK PPS Stryker Smith & Nephew Zimmer Biomet Medtronic

143 P/EBITDA Comparable Company Market Cap($Bill) EBITDA($Bill) P/EBITDA Industry Avg. SYK PPS Stryker Smith & Nephew Zimmer Biomet Medtronic P/FCF Comparable Company Market Cap($Bill) FCF($Bill) P/FCF Industry Avg. SYK PPS Stryker Smith & Nephew Zimmer Biomet Medtronic Enterprise Value/EBITDA Comparable Company EV EBITDA($Bill) EV/EBITDA Industry Avg. SYK PPS Stryker Smith & Nephew Zimmer Biomet Medtronic

144 144

145 Discount Dividends Model WACCT kd ke DPS pf factor pv of Dividend pv of YBY pv of Div Perp pv tv perp Implied model price Growth Rate Time consistent price upper bounds undervalued lower bounds overvalued ke Book Value of Debt and Preferred Stock Observed Price Initial Cost of Equity Perpetuity Growth Rate (g) 8 Shares Outstanding growth <---growth rate 0 14

146 Abnormal Earnings Growth Model perp Net Income Total Dividends DRIP Cumulative Dividend Income Normal (benchmark) Income Annual AEG Annual change in residual income PV Factor PV Annual AEG PV YBY AEG adj to "Core" Core 1 yr out Earnings Perp pv tv aeg adj total adj forward earnings perp Divide by ke Time Zero MVE Growth Rate Divide by shares time consistent price upper bounds >undervalued Ke lower bounds <overvalued Annual Change in residual income Book Value of Debt and Preferred Stock Observed Price Initial Cost of Equity Perpetuity Growth Rate (g) 0 Shares Outstanding

147 Long Run Return on Equity Perp Net Income Total Dividends Book Value of Equity ROE Equity growth rates NI BE ROE Growth Rates ROE=24.64% Ke upper bounds undervalued lower bounds overvalued Book Value of Equity Long Run Return on Equity 24.64% Cost of Equit y 11.31% Long Run Growth Rate 8.00% 0.08 Growth Rates Value of Firm Number of Shares Share Price Ke=11.31% ROE upper bounds undervalued Time Consistant Price lower bounds overvalued Observed Share Price 4/ 1/ ROE upper bounds undervalued Book Value of Debt and Preferred Stock 1976 g=8.00% Ke lower bounds overvalued Observed Price Initial Cost of Equity Perpetuity Growth Rate (g) 0.08 Shares Outstanding

148 Residual Income Model Perp Net Income Total Dividends Book Value of Equity Annual Normal Income (Benchmark) Annual Residual Income pv factor YBY PV RI Book Value Equity (Millions) Total PV of YBY RI Terminal Value Perpetuity MVE 12/ 31/ Growth Rates divide by shares Model Price on 12/ 31/ time consistent Price upper bounds Ke lower bounds Observed Price Initial Cost of Equity Perpetuity Growth Rate (g) Annual change in residual income

149 Free Cash Flows Model WACCBT kd ke Perp Net cash provided by operating activities Net cash used in investing activities FCF Firm Growth PV Factor PV YBY FCF PV TV Perp Total PV YBY FCF Time zero PV TV Perpetuity Growth Rates Market Value Asset Total Market Value of Equity Divide by number of Shares upper bounds >undervalued Intrinsic Price (12/ 31/ 07) lower bounds <overvalued WACC Time consistant Price Book Value of Debt and Preferred Stock Perpetuity Growth Rate (g) observed 12/ 31/ observed 5/ 01/

150 Reference Page 1. Stryker Corporation: 2. Yahoo Finance: 3. United States Department of Justice: 4. International Trade Administration: 5. Hoovers: 6. Scottrade: 7. The Wall Street Journal: 8. Google Finance: 9. IBS: Palepu, Healy and Bernard, Business Analysis and Valuation (Ohio: Thomson-Southwestern, 4 th edition, First Research: Investopedia: SEC Filings: Stryker 10-K Biomet 10-K Zimmer Holdings 10-K Smith & Nephew 10-K Medtronic 10-K 14