In the healthy and growth inducing economic scenario of the 2000’s, P&G has seen double digit revenues growth to around $56b in 2005. Keeping its costs low has seen it achieve healthy profit margins of around 11% – 12%. Refer Table 1.
(in %) 200320042005
Gross Margin 4951.251
Profit Margin 11.9612.6112.79
Financial Health: P&G is a stable company operating in a very mature and stable steady growth industry. It has an average Return on Assets of 12.5% and a high average Return on Equity of 43%. It turns its Inventory around 12 times a year, which is also an industry average .
One weak aspect of P&G is its relatively poor liquidity position. One reason is the high STD (short term debt).
P&G, being a low risk firm is able to get STD at low interest rates and hence uses this instead of LTD. It generates huge positive free cash flows to ensure prompt payment of interest. I feel P&G prefers STD due to its speed and flexibility (no covenants).
Another reason for the low liquidity is its almost equal balance between its A/R and A/P. While a firm of its size should be able to work on its supplier’s capital, P&G surprisingly has not been able to that. Unilever has the highest A/P deferral period in the industry, thus leveraging its size to get a better bargain from the suppliers. P&G however, has an industry average A/P deferral period. The only reason I see P&G doing that it believes in treating suppliers better than its competitors by paying them on time as promised. This is part of P&G’s best practices philosophy and also of treating suppliers as partners. Therefore this weak position is not an indication of poor financial management, rather a reflection of good relations with suppliers.
... European average Low inflation rate Competitive capabilities: In spite of the strong impact on the environment, Danish pig industry still ... (Tinnggard, 2003). 3. Competitive pressures stemming from suppliers Whether suppliers represent a weak or strong competitive force depends essentially ... and also because they would not have big profit margin. The competition between TiCan and Danish Crown is ...
P&G finds itself in a commoditized market, with most of its products required for daily use. Growth in this industry depends on demographic factors such as population growth and advertising and marketing strategies more than anything else. Hence it can have leverage itself by issuing long term debt which currently is 14% of its total capitalization.
Efficiency Ratios: P&G has an average CCC of around 40 days . A firm like P&G should ideally have a negative CCC. Its closest competitors like Unilever and JNJ have managed CCC of (57) and 12 days respectively. It has to adopt stricter policies with its suppliers and reduce its Inventory conversion period. However, given the stable nature of the industry these will be difficult tasks. It will be difficult to change methods adopted by old suppliers.
Sustainable Growth: P&G is experiencing average revenue growth of 12% and average sustainable growth rates of 28%. This suggests that P&G can grow at this rate without borrowing any additional funds.
Dividend Policy: Given the stable industry that it finds itself in, P&G’s capital expenditures as compared to firms in high growth sectors like Technology are low. In fact CAPEX as a % of sales is less than 4%.
Therefore, P&G can have a high payout ratio, because its need for funds is low. The average industry payout ratio is 40%. Thus we would expect most firms in the industry to pay regular dividends.
In fact, P&G has not only been paying regular dividends since its inception, since the last 50 years it has been paying regularly increasing dividends.
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P&G faces direct competition in all its product segments from worldwide leaders like Unilever, Kimberly Clark and Colgate – Palmolive.
Unilever N.V: Unilever N.V is a parent company of Unilever Group. It is divided into the Foods and Home & Personal Care division. It competes with P&G with brands like Dove, Lux, Omo and Surf. It had sales of around $50Billion and has 223,000 employees worldwide. Unilever has significantly higher debt than P&G, but its LTD is about the same % of total Liabilities as P&G. Typical to the industry even at sustainable growth rates of 52.52% UL doesn’t need to borrow additional funds. Like P&G, it too is using internally generated funds to achieve growth. It has suffered from negative growth in revenues, partly due to its strategy of divesting its non-core businesses. But this strategy is paying off well as its Net Income has improved as a result of these measures as also its profit margin .
Kimberly Clark (KMB): KMB is divided into three business divisions – Personal Care, Consumer Tissue and Business-to-Business. KMB makes brands such as Kotex, Huggies and Depend. It is a relatively medium sized but strong competitor to P&G’s brands like Pampers and Luv’s. It has the highest CCC in the industry and should reduce that to the industry average. While revenue growth is around 5%, the operating income has shown negative growth in 2005. This is a result of a drop in its profit margins. It needs to reduce its COGS as a % of sales which is one of the highest in the industry. Like other firms in the industry, KMB is able to meet its growth through internally generated funds. True to the nature of the mature industry that KMB is in, it has been paying a steady increasing dividend payout ratio .
Colgate – Palmolive (CL): CL manufactures and markets a variety of products in the United States and worldwide through two business segments: Oral, Personal and Home Care, and Pet Nutrition. Its products include baby care, deodorants, shampoos, soaps and bleaches, laundry products, and washing soaps. It is a medium sized but strong competitor to P&G’s personal care products. CL has given exceptional ROE of above 100%. The firm is growing at exceptional sustainable growth rates of above 50%, but like other firms in the industry will need to borrow substantial funds to maintain the rate. The high ROE is probably due to the fact that the market recognizes its growth prospects. Like other firms in the industry, CL is paying out a steadily increasing dividend .
... Presently, Allied Healthcare Products, Inc. (AHPI) manufactures a variety of respiratory products utilized in the health care industry in a wide ... variety of hospital and alternate health care settings, ... specializing in the manufacturing of medical equipment. Allied Healthcare Products, Inc. (a unit of Harbour Group Investments, LP ...
Procter & Gamble (P&G): For the period 2005 – 2010 the World GDP is projected to grow at 3.1% annually.
I have made certain assumptions to facilitate the forecast:-
1.Growth rate of 7%. Basis: P&G has completed a $57b acquisition of Gillette. I have included Gillette’s sales of $10.5b in my forecast. Following the successful merger P&G has revised its sales forecast from 6-7% to 5-6%.
2.Gillette sales of $10.5b included in forecast.
3.Benefits of synergies i.e. reduction in COGS, SG&A not included. I have kept them at 2005 levels even though I believe that the benefits should be visible within the period.
4.Income tax – 31%
5.Dividend Growth Rate – 5.41%
6.Preferred Dividends, Intangibles, Net PPE, LTD, and Equity is constant over the period.
7.Other Long Term Asset’s – 4.76% of sales
8.Net Interest Income – same from 2007 to 2010 = -488m
Table 2 below shows the forecasted sales for the period.
Sales70,630,299,996.60 75,246,599,995.49 79,862,899,994.36
Sales84,479,199,993.23 89,095,499,992.10 93,711,799,990.97
Using the Percentage of sales growth method, I have forecasted the income statement and balance sheet.
Based on the calculations, Table 3 highlights the need for additional funds during the period.
P&G’s sustainable growth rate is 29.33% (g = ROE * Retention Ratio – 45.71%*64.16% = 29.33%).
This means that P&G can grow at the rate of 29.33% without the need for additional funds. Thus, it can fund its growth using internally generated funds.
Table 3 above validates the above conclusion. P&G has a negative AFN over the period, which means that far from any additional need for funds, P&G in fact has excess funds which it can reinvest in the business or use to maintain its dividend payout ratio. Refer Table 4.
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FCFF14,813,819,710.13 15,780,365,797.42 13,209,246,429.73
P&G is able to maintain very strong free cash flows during the period, Table 5 will show us. Thus it is a further validation that P&G will continue to use internally generated funds for its operations and acquisitions in the future also.
Key Ratios status during the period:-
Inv T/O11.33 11.33
Total Assets T/O0.92 1.12
Thus, we see that the key ratios are maintained and the profit margin, ROA, and the total assets turnover ratios are improving. P&G still finds itself in a tough situation as far as liquidity is concerned with the liquidity ratio showing a further decline.
P&G acquisition of Clairol: 2001: P&G acquired Clairol in 2001 for an all cash deal of $4.95b . The basic motive was the $1.6b hair care business of Clairol. The Herbal Essences line of Clairol was the market leader in the hair color segment, where P&G had no presence. Thus P&G, instead of developing its own hair color internally, chose to acquire the 2nd largest player after L’Oreal.
P&G, which had seen stagnating sales in 2000, experienced 2.5% increase in revenues after the Clairol acquisition . P&G achieved economies of scale in its distribution and marketing expenditure as it distributed Clairol with its existing line of products.
P&G acquisition of Wella: 2003: P&G acquired Wella, a leading marketer of beauty salon products for $5b in 2003. P&G paid $3.2b in cash and the balance was in the form of stock. P&G was looking at geographic expansion into Europe and Latin America as well as expanding its current line of hair care products including Clairol. With the acquisition of Wella, the total hair care business grossed $7b in revenues. P&G leveraged Wella’s market leader status in Europe and Latin America with its strength in the US to achieve dominant position in the women’s hair care segment. Wella was the market leader in professional hair care products, most of which were sold in the beauty salons. P&G sought to complement the sales of the professional care products of Wella with the personal hair care products like Pantene, Head & Shoulders and Herbel Essences from Clairol.
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Classic brands like Gucci and Montblanc from Wella found complements with P&G’s Hugo Boss perfumes. The acquisition again gave P&G significant synergies in terms of marketing, distribution and procurement. Wella’s inclusion lead double digit growth in revenues in 2004. Sales increased by 18.5% in 2004 as compared to 7.8% in 2003 .
P&G’s acquisition of Gillette: 2005: With the acquisition of Gillette, P&G is now better positioned to provide goods for the entire household. P&G’s primary motivation behind acquiring Gillette was to create a presence in the $5.5b male grooming segment, where it was absent so far. With the acquisition of Clairol and Wella, P&G had achieved dominant market share in the women’s hair care segment. Pursuing its strategy of entering new markets and product segments via the acquisition mode, P&G acquired Gillette for a deal worth $57b. Gillette bought with it world class market leader brands like Mach 3 Razor, Duracell, Oral-B, Right Guard and Braun. Thus, P&G not only entered the men’s grooming segment but also the gadget market (razors, electric shavers, and electric toothbrushes) with the Braun brand on board. Thus, P&G hoped to complement its sales of toothpastes like Crest with electric toothbrushes from Braun as a way to build brand loyalty and increase sales. P&G is now using the Braun technology to create battery and electric powered brushes for cleaning clothes thus complementing Tide and other detergent sales. Thus P&G will find its products in the male aisles too, a place where it was absent before. Gillette will contribute $10b in sales to P&G’s top line. Gillette will bring 31 plants in 14 countries especially in countries like the BRIC countries and a strong distribution network which will lead to strong synergies and significant cost reductions. P&G expects to achieve revenue and cost synergies of about $14b to $16b mainly through the scale of the combined company applied to leveraging P&G’s unique organization structure, removing duplicate costs and driving further efficiencies.
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P&G’s acquisition of Fabric & Home Care Trademarks: Greece, 2005
P&G acquired a number of brands in the fabric and home care segment in Greece in 2005 to boost its presence and achieve synergies and economies of scale in marketing and distribution. The total value of these brands was Euro 33m .
Analysis of the P&G acquisition strategy: All the acquisitions have been made in the P&G Beauty business unit. The Beauty unit is the most profitable and fast growing segments. From the acquisitions that P&G has made since 2001 a clear trend is emerging. P&G is seeking to diversify its business risk by expanding into different geographies and different market segments where it had no presence earlier. In a break from its sole dependency on its internal R&D, it has chosen to achieve its purpose by acquiring market leader brands. Through its acquisition of Clairol and Wella it has successfully expanded into the higher margin hair care women’s market. It has thus successfully entered the hair color and the beauty salon markets and markets in Europe & Latin America through the acquisitions. By acquiring Gillette, P&G has successfully entered the male grooming segment where it was absent. By acquiring Clairol, Wella and Gillette, P&G has acquired complementary brands and products which will help it achieve synergies of scale in marketing, distribution and promotion. It will also help P&G to gain better bargains from retailers for shelf space. By adopting the acquisition strategy, P&G is achieving rapid sales growth not only in the US but also in the geographies where it has expanded. Thus this acquisition strategy has reduced the business risk by reducing its dependence on the US sales. Its global focus now will help it diversify its business risk. Now that it is represented in almost all segments of the market for kids, women, men and pets, it has reduced its business risk by achieving economies of scale and significant cost reductions in distribution and marketing related expenses . P&G, by moving into the high margin products is trying to carve a niche for itself and differentiate itself.
P&G’s acquisition of Gillette has a positive NPV and an IRR greater than the WACC and hence is an investment which will create value for shareholders .
With these acquisitions, P&G has created for itself a range of Real Options.
Growth Options: I feel the strategy to acquire complementary products will create and in fact is already creating a number of growth options for P&G. P&G can combine a number of fairly unrelated products like the Crest Toothpaste and the Braun Electric Toothbrush and gain a unique competitive advantage over competitors who lack such technology.
Flexibility Options: By taking complementary brands on board, P&G has created flexibility in terms of the distribution and supply chain strategy. Now P&G can optimize its supply chain to reduce carrying costs by supplying a bulk of products to a single retailer like Wal*Mart. It can also cross dock since it has a multitude of brands now.
Competitor Investment Analysis
Unilever: In the past five years the only major acquisition by Unilever has been of BestFoods, a US based manufacturer for $24b, in 2000. The motive behind the acquisition was part of Unilever’s strategy of investing in growth areas (Path to Growth Strategy, 2000) . The geographic reach and product portfolio at BestFoods would complement Unilever’s existing offerings. The acquisition would enable significant cost reductions in operations due to synergies of scale, besides the acquisition would enable Unilever to share BestFoods distribution network i.e. its foodservice channel could promote Unilever brand tea and beverages . In fact during the past few years, Unilever has sold off a number of its business like Mora, its Dutch snack foods division, frozen pizza and baguette business, closing its Elmlea plant etc. I feel this is a strategy in which it, like P&G and others in its industry has decided to focus only a few core brands i.e. brands which get highest revenue or brand recall and phase out or divest brands which are not core brands.
KMB (Kimberly Clark): With $15 billion in sales worldwide in 2005, Kimberly-Clark Corporation is a leading global manufacturer of tissue, personal care and health care products. KMB’s B2B division (24% of revenue) has seen major acquisitions in the medical devices segment.
In 2005, KMB acquired S-K Corporation which held trademark and distribution rights in Taiwan for such Kimberly-Clark global brands as Kleenex, Huggies and Kotex. The objective was to become the largest manufacturer of consumer packaged goods in Taiwan. KMB has been following a strategy similar to Unilever and P&G’s i.e. entry via acquisition into high growth high margin areas where it lacks presence. It is rapidly acquiring firms in the health sector as it seeks to become a major player in the medical devices and health sector .
In 2002, KMB acquired Safeskin Corp for $800m. The acquisition of Safeskin has allowed KMB to leverage its existing products, distribution channels, sales force and technologies as it seeks to expand into new health care segments and markets. Safeskin’s state-of-the- art, low-cost manufacturing facilities in Thailand also complement Kimberly-Clark’s existing tissue and personal care operations in that country. With this acquisition KMB gained an entry into the $3b medical glove market. In 2003, KMB acquired Klucze Corp, Poland which was a leading manufacturer of tissues thus expanding market share in eastern Europe.
In 2005, KMB acquired Microcuff GMBH Germany, a medical devices manufacturer for $16b consistent with the strategy of becoming a complete provider of innovative medical device and health care solutions .
CP (Colgate Palmolive): CP has been making significant acquisitions in its core Oral Health business segment. In 2003 it acquired the German oral health care company Gaba Holding AG to bolster its presence in Europe. The Gaba acquisition allows CP to enter into the Pharma value chain while allowing Gaba’s products to be sold through its mass retail outlets. In early 2006 CP has announced several acquisitions such as investing US$20M to acquire a stake in Texas-based gene-therapy company Introgen Therapeutics, to reinforce its position in oral health. It is also bidding to acquire Pfizer’s consumer business unit and has bid $10b for it .
Financing Decisions: In the FMCG industry, the primary need for long term debt arises for acquisitions while that of short term debt arises to meet working capital requirements or advertising & promotional expenses.
Despite belonging to a stable and mature industry P&G has a low debt ratio, i.e. D/V ratio of 14.27%. This implies that it is able to utilize its internally generated funds to meet its capital needs . The low debt ratio gives P&G flexibility in terms of raising additional funds immediately from the market should the need arise. The low debt ratio gives it an AA bond rating which gives the firm the flexibility to raise funds in the bond market at competitive interest rates. A high credit rating would thus ensure that P&G is able to raise funds at a lower interest rate during adverse conditions. I have used the APV method to calculate the Optimal Capital Structure for P&G in 2005 . The APV method recommends a debt ratio at the value that maximizes the firm value. In P&G’s case, the optimal capital structure would be 35% thus giving it a credit rating of BBB. I feel that P&G has kept a low debt ratio primarily because its need for long term debt is limited to acquisition opportunities and to afford itself the flexibility to borrow at low rates of interest. P&G’s current ratio of 0.81 as opposed to an industry average of 1.31 should set alarm bells ringing. But it is a risk that P&G can live with. P&G, due to its excellent relationship with suppliers and customers (read Wal*Mart) has the lowest DSO and among the lower Payables deferral period giving it a cash conversion cycle that is the least in the industry. Thus it can maintain its aggressive stance given its market leader status .
P&G generates stable free cash flows of around $6.5m which are 11.53% of sales. It also has a retention ratio of 64.16%. Thus, it is able to meet its financing needs from its internally generated funds. Even when it acquires firms like Gillette, Wella or Clairol it has mostly financed through equity i.e. issued 0.975 stock for every stock of Gillette and a buy back of Gillette shares.
Thus, P&G’s decision to maintain a lower D/V ratio ensures that it has a lower financial risk by limiting its short term interest payout ratio coupled by its ability to generate sufficient free cash flows. Taking on higher level of debt would entail interest payment obligations and reduce the free cash flows thus increasing the need to borrow externally.
Risk: As stated earlier, P&G belongs to the FMCG sector, a sector which experiences classic growth i.e. stable, mature growth year on year. This is because the FMCG sector produces commodity everyday use products. Thus growth is a function of demographic trends like increasing population, social trends like increase in disposable income and the firm’s decision on advertising & promotional expenses as a % of sales. So, like most other firms in the industry, P&G enjoys a low business risk. P&G also benefits from having the most diverse portfolio of brands which serves all levels of income. Its brands dominate all the categories that it is present in. Only in times of recession does it see a dip in demand, but it doesn’t suffer as badly as firms in other industries as it produces everyday use products, something which people can consume less off, but not stop the use off altogether. It influences consumer demand by trying to achieve differentiation through innovative advertising campaigns.
The firms Beta is an indication of its risk. P&G has a beta of 0.76 . This is an indication that the firm carries below average risk than the other firms in the industry. The biggest risk P&G and other firms in the industry face are of trademark violation, imitation and false advertising by competitors. In most of the less developed countries, it is common to find product imitations which depress sales figures. P&G is routinely involved in infringement suits, the verdict of which can affect its stock price. Another risk which is common to all firms is the rising prices of oil. The current strategy is that of entering higher margin, high growth products like that of the beauty segment. Here too, P&G has reduced its risk by acquiring established brands like Wella and Clairol, instead of spending huge sums of money on R&D. P&G is reducing business risk by balancing the mix of its customers, geographies and products.
We see that P&G’ standard deviation for growth in EBIT, EPS and Operating cash flows is relatively low, a measure of its stable demand, growth and hence its low business risk . The implications of this stable standard deviation mean that P&G can ideally incur higher debt till its optimum capital structure or even higher in times of need and yet maintain the stability primarily due to the nature of the business it finds itself in.
Income: P&G’s EPS in 2005 was 2.9 while the ROE was a healthy 45.71%. P&G’s decision to maintain a ratio of 14.27% means that it does not benefit from the interest tax shields from issuing debt at the optimal capital structure.
However, maintaining a lower debt ratio reduces its probability of default and reduces the rate of return demanded by investors. P&G can improve its EPS and ROE even further by incurring more debt and increasing its earnings.
P&G’s WACC stands at 8%. A lower WACC is a further indication of the low risk that P&G has. A lower WACC allows P&G faster payback on projects and also enables it to take up riskier projects than its competitors. Faster payback leads to faster contribution to earnings and thus higher income. This faster payback thus ensures faster cash back into the system thus reducing its need to borrow additional funds.
Control: Table 4 shows us that majority of the shares are held by institutions and mutual funds. Since P&G has a very low % of debt, creditors cannot influence any control or impose covenants which would impede the normal running of the firm. Control is firmly in the hands of the stockholders. Increasing the % of debt will lead to some control transferring into the hands of the creditors. This could restrict P&G in its future strategy as the creditors may impose covenants which impede flexibility of movement in the market.
Timing: Given the limited investment opportunities that it faces, P&G doesn’t have any need to change its current capital structure since it is able to fund its growth with its internal funds. P&G has completed a major acquisition of Gillette for $57b. I think that for the next few years it will be consolidating its synergies achieved with this acquisition to justify the acquisition price to the investors which means that it will not be considering any major acquisition for a few years at least. However, the current market situation with stable interest rates and a growing world economy especially high growth in the BRIC countries suggests that it is a good time to issue long term debt . Anyways, the optimal capital structure for P&G is 35% debt at which it will further be able to reduce the WACC and maximize the firm value. However, as I mentioned earlier given the limited investment opportunities there is no real need to issue any long term debt. For P&G issuing additional debt to bring it to the optimal capital structure will maximize its market value and further reduce its WACC, but it will face potential impediments like the risk of meeting creditor’s covenants and fixed interest payments, which could harm the growth.
Kimberly Clark (KMB): As compared to P&G, KMB is a small company. However, like P&G it too has made a number of acquisitions in the past few years.
Flexibility: Like P&G, KMB too has a low dependence on debt. Its debt ratio is even lower than P&G’s at 11.96%. It too is utilizing its internally generated funds to run the company .
Thus, like P&G, KMB enjoys a high level of flexibility in terms of its ability to borrow debt .
Risk: Compared to P&G, KMB faces a slightly higher business risk. The primary reason is that P&G dominates across all sectors and is the market leader in all categories. So KMB mostly plays catch up. 13% of KMB’s sales come from Wal*Mart as opposed to 10% for P&G. It also doesn’t enjoy the geographical and product balance that P&G enjoys. Thus its revenues are dependent on relatively smaller group of customers, products and geographies.
KMB, like P&G has a beta of 0.76 . As I said, this is a reflection of the low risk the market accords this industry. Compared to P&G, despite having a negative growth in EBIT and EPS, the standard deviation in EBIT, EPS and operating cash flows is still less than P&G’s .
Income: KMB has an ROE of 25.89% and EPS of 3.32. KMB also enjoys a low WACC of 7.8%. Thus, like P&G it can achieve faster payback on its projects. The APV method suggests an optimal capital structure of 35% for KMB . However, like P&G it too should not issue debt since there is no pressing need for it.
Control: Institutional ownership in KMB is 71% . Thus, like P&G creditors do not exert any significant hold over the firm’s daily operations and strategies. Thus, typical to any American firm, a varied shareholder base and no single chunk holds control over the firm.
Timing: As mentioned in Journal 3 KMB is acquiring a number of firms in the medical devices sector and may require additional funds in case it needs to acquire a large firm like in the case of P&G and Gillette. In that case, the market with its low interest rate fluctuations and growth in interest rate and a growing world economy especially the BRIC countries, KMB may increase its debt ratio to 35% which would still reduce its WACC and maximize its firm value.
Colgate – Palmolive (CP)
Flexibility: CP, like KMB and P&G generates funds for its operations through its internally generated cash flows and retained earnings .
It has among the lowest Cash conversion ratios in the industry . Thus it is using free funds from suppliers to fund its daily operations.
Again, like KMB and P&G it maintains a high degree of flexibility to scale up its debt structure in times of need.
Risk: CP is the smallest of the three comparable firms and hence faces a higher business risk as compared to P&G. However, CP, like KMB and P&G is reducing business risk by diversifying its customers, products and geographies.
It has the lowest standard deviation of growth in EBIT, EPS and operating cash flows. CP has a beta which is even lower than KMB’s at 0.66 . Thus among all the three firms, the market perceives it to have the least risk .
Control: Institutional investors hold 67% of CP’s shares . Low debt ensures that creditors do not influence decisions. Thus, typical to any American firm, a varied shareholder base and no single chunk or owner holds control over the firm.
Timing: CP is also acquiring a number of firms as the industry consolidates further. As is the case with KMB and P&G, CP doesn’t really need to increase its debt to the optimal capital or even higher or lower than what it is .
Procter & Gamble (P&G)
Shareholders: P&G has been paying out dividends since its inception in 1890. The year 2006 marks the 50th consecutive year that P&G has been paying increased common dividends. On an average, the firm has been increasing its payout ratio by almost 10% every year .
When we analyze the “clients” i.e. the shareholder profile of P&G we see that almost 82% of the shares are held by either Institutions or Mutual funds. Most of the institutional and fund owners have invested in P&G for regular payments i.e. regular returns to their respective clients. If we look at the average age of a mutual fund owner it would roughly be around 35-40 . Thus, I assume that most of the shareholders would be middle income, middle aged to older people who have invested in P&G for a fixed return. Institutional buyers also have an obligation to give regular returns to their investors and hence a firm like P&G with its regular dividends makes a good investment.
Given the importance of the clientele effect and the signaling theory, it is important for P&G to maintain its current policy of increased dividend payouts. Any deviation from its current high standards would signal a negative effect on the stock market and may cause panic and a subsequent reduction in its stock price and market value.
Table 2 shows that based on the Residual Dividend Model P&G can afford to pay out almost 74.23% of its Net income but chooses to payout only 35.84%. Thus P&G has adopted a conservative policy to maintain a steady dividend policy and avoid giving any negative signals to the market . Should it have chosen to follow the residual dividend model it would have seen great variations in its payouts. In the event of a less than normal payout, the market would have assumed trouble with the firm and seen a dip in the stock price.
Thus by maintaining this conservative profile, P&G is able to utilize internally saved funds to run its daily operations and even fund acquisitions with minimal debt. This is reflected in its low debt ratio of 14.27%. Even though it has reduced its payout ratio, in absolute terms the dividend per share is increasing by 10% on average.
P&G is a firm with a very strong history of robust growth in sales and earnings. In fact in 2006, even though the firm had to correct its growth estimates from 6-7% to 5-6% after factoring in the effect of its $57b acquisition of Gillette, it announced a 12% increase in the quarterly dividend. It is not surprising that the market has rewarded P&G for its exceptional performance with an increase in its stock price. In fact over the past few years P&G has delivered a cumulative shareholder return of 81% while the price of its stock has increased more than 70%. As Table 4 suggests , the firm has had to affect stock splits in regular intervals since 1970 to keep its price in check and to allow a larger base of investors to invest in it. In its entire history, P&G has not felt the need to repurchase its shares to boost its EPS. In 2002, following its spinoff of the Jif/Criso business unit, P&G announced a special dividend/share of $0.345 as opposed to the regular quarterly dividend of $0.19 that year. Thus we see that P&G believes in sharing its gains in the form of special cash dividends with its investors.
P&G has a Shareholders Dividend reinvestment plan (SIP) which allows its shareholders to reinvest its cash dividends to purchase additional stock. The SIP is designed to make it convenient for the shareholder to purchase stocks thus avoiding brokerage fees and other issuing costs to the shareholder and P&G respectively.
P&G has consistently been outperforming the S&P 500 index in terms of dividend yield. As Table 5 shows P&G has been giving almost 50% higher returns than the index.
Given the factors mentioned above, I find that the current policy of distributing increased and regular cash dividends appropriate for a firm like P&G. Its policy of a conservative payout policy helps it maintain a positive signal to the market and allows it to use its internal funds to run the firm and avoid issuing debt.
Employees: It’s interesting to note that P&G initiated a profit sharing plan in 1887 itself. Currently, almost 18% of the firm is owned by the employees through ESOP’s . Every one of P&G’s 110,000 employees is given P&G stock as part of the company’s One Share program, and employees not in current stock option plans were recently given a 100-stock option grant. New workers are given 100 options and 50 additional for work that goes beyond the call of duty. As mentioned earlier, P&G was among the first to introduce a direct stock purchase plan primarily intended to allow employees and retirees to “roll over” dividends into equivalent amounts of P&G stock purchased directly through the company and not through a brokerage through its SIP plan.
Other Stakeholders (Customers which include retailers & distributors, and Manufacturing Contractors): I have included these stakeholders together as distribution of profits for these parties is not in the form of cash but in the form of cost reductions and reduced prices and increase in efficiency. Wal*Mart and other large retailers contribute to a majority of P&G’s sales. Through point-of-sale (POS) information P&G is able to reduce its inventories and manufacturing lead times across the supply chain thus reducing holding time. Thus through better information management, P&G enables its suppliers and distributors to achieve economies of scale and hence optimize costs. By acquiring complementary brands like Wella, Cloirol and Gillette P&G has created synergies in manufacturing & distribution by combining operations to achieve economies of scale and also in retail wherein it has increased its shelf space and hence bargaining power to get better deals.
As a result the savings and reduction in cost as passed on to the customers in the form of reduced prices.
Society: P&G has been ranked 2nd on the global 100 best firms in corporate social responsibility . P&G has been generous in international grants and gifts in the countries that it operates in including earthquake relief in Turkey, community building projects in Japan, plus contributions for schools in China, school computers in Romania, special education in Malaysia, and shore protection in France . P&G provides PUR pure water to relief agencies like UNICEF, AmeriCares, and CARE around the world. Thus P&G returns its profits back to society in the form of social and philanthropically initiatives by actively working with NGO’s and not for profit organizations.
Kimberly Clark (KMB)
Shareholders: Like P&G, KMB too has been generous in its dividend payout policy program. LMB has been paying quarterly dividends since 1934 and 2006 marks the 34th year of increasing dividends (average growth 10%).
As mentioned in Journal 4, almost 71% of shares are owned by mutual funds and institutional investors who demand a regular rate of return. Like P&G, KMB too in the interests of maintaining a steady payout ratio has maintained a conservative payout policy .
KMB has regularly split its stock in order to maintain its optimal price range .
KMB has also embarked on share repurchase programs starting 2000. Since 2001, KMB has repurchased approximately 70 million shares and reduced shares outstanding by nearly 57 million to 476.6 million as of 2005. Like P&G, KMB too has been generous to share its proceeds from its spin-offs in the form of additional cash dividends.
Thus, in contrast to P&G, KMB has adopted the share repurchase program and the cash dividend distribution model to share profits with its shareholders. KMB does this not only to maintain its target D/V ratio but also to send positive signals to the markets that the management is confident of its earnings prospects. KMB’s dividend yield is outperforming the S&P 500 by almost 100% .
Employees: Like P&G, KMB has been generous in its stock options policy too. The stock options are not just reserved for higher executives but also rank and file employees. Grants are made on the basis of past contribution and future performance.
Other Stakeholders (Customers which include retailers & distributors, and Manufacturing Contractors): KMB through its acquisition of complementary products has been achieving economies of scale in its distribution and retailing. KMB has launched an ambitious cost reduction program by streamlining manufacturing operations globally which is expected to generate savings of $1.1b by 2008. By combining products together, KMB has been able to reduce distribution costs. Like P&G, KMB has been getting better deals from retailers due to its increased shelf space.
Society: KMB has an active corporate social responsibility program (CSR).
The firm views the CSR initiatives as a way of giving back its profits to society. KMB has contributed millions of dollars to rehabilitation efforts for Hurricane Katrina and in the tsunami disaster in Asia. Like P&G, KMB too partners with NGO’s and non-profit organizations in education programs for children in the countries it operates.
Shareholders: Like its competitors, CP has paid dividends since is inception in 1895 and has been paying out increased dividends for the last 43 years . CL too has a majority ownership by institutional investors who demand fixed and increasing returns to satisfy their clientele.
It has undertaken stock splits regularly like KMB and P&G to bring its rising stock price to a “normal” range . Like KMB, CL has announced a share repurchase program amounting to 30 million shares over the next 2 years. Like KMB and P&G, CL has adopted a conservative payout profile to maintain a steady increasing dividend payout policy . Thus CL gives the market a positive signal regarding growth in earnings while allowing it to maintain its target D/V ratio.
Employees: Like KMB and P&G, CL too has an employee SOP. The SOP only extends to the top management unlike KMB and P&G which have extended the plan across all levels though at different rates.
Other Stakeholders (Customers which include retailers & distributors, and Manufacturing Contractors): Similar to the strategy adopted by P&G and KMB, CL too has sought to reduce costs across the supply chain. As part of its strategy to reduce costs, CL has acquired complementary brands to achieve economies of scale in manufacturing and distribution. It also seeks to leverage this increase in its portfolio with the retailers by increasing its shelf space and getting better deals.
Society: CL has an active CSR program which involves employees in education, health and other programs of social interest in the countries where they operate.
Procter & Gamble (P&G): As mentioned in Journal 5, all employees of P&G are stockholders as well and hence share the profit. Thus P&G ensures goal congruence by aligning the economic interests of the firms with that of the stockholders.
82% of P&G’s stock is in the hands of institutional investors. These investors though hold P&G stock in small parts only with any investor rarely holding more than 1%. However, the combined strength of these investors makes them a force to reckon with. These investors, through proxy statements and shareholder action committees exert significant weight on governance and it is very important to satisfy this group.
P&G has laid down very strict guidelines for selection and continuation of the Independent Board of Directors (BoD) . These guidelines – by setting financial and personal checks and limitations – prohibit any person who is directly or indirectly involved with P&G or its subsidiaries from becoming or continuing as a board member. P&G maintains the sanctity of its board by rigorously following these guidelines.
A number of committees help the BoD function effectively. The various committees are the Audit, Compensation & Leadership Development and the Governance & Public Responsibility Committees. The function of the Governance & Public Responsibility committee is to assist and guide the board in its various functions and duties to ensure proper functioning of the BoD. The committee also has additional duties maintain the integrity and characteristics of the board. The Audit committee meets regularly with external auditors Deloitte & Touche to verify the various financial statements and ensure their integrity. Thus with this system, P&G ensures strong internal controls on its processes.
Through its Global Leadership Council P&G continuously reviews its business results and strategies.
P&G has also initiated a Disclosure Committee to ensure that information required to be disclosed is recorded, processed, summarized, and reported timely and accurately. The Disclosure Committee is comprised of a group of senior-level executives responsible for evaluating disclosure implications of significant business activities and events. This committee is supposed to report its findings to the CEO and CFO, thus providing an effective process to evaluate its external disclosure obligations.
In its Worldwide Business Conduct Manual, P&G has laid down “broad” guidelines for the ethical conduct of business.
Through the above mentioned committees P&G ensures proper internal & external controls to ensure accountability amongst its employees and management. These committees work as safeguards and serve as an incentive to do work properly and as per regulation.
It is the responsibility of the CEO to ensure the BoD has all the necessary and relevant information about the affairs of the firm.
Corporate Governance at Unilever: Unilever is an Anglo-Dutch firm comprising Unilever NV in The Netherlands and Unilever PLC in the UK. Even though they are listed in different stock markets and have different legal systems they try to operate as a single entity. To this effect, they have a single tier BoD which comprises the same people. The board is split into independent Executive Directors and a majority of Non Executive Directors. The Non Executive Directors serve on key committees like the Audit Committee, the Nomination Committee, the Remuneration Committee, the External Affairs, the Corporate Relations Committee and the Disclosure Committee. All these committees report to the CEO and CFO. As in P&G, these committees serve to ensure accountability and safeguards for proper funtioning of the BoD. The Directors are required to set strategic goals, provide leadership and maintain the values and standards as outlined in the Code of Business Principles. There are no family relationships between any of the Executive Directors, other key management personnel or Non-Executive Directors.
All Directors should see to it that they are informed on a timely basis and in sufficient detail about all important matters relating to the company and the functioning of the Board. The Group Chief Executive has a particular responsibility to ensure that the Chairman promptly receives timely and clear information (in particular about the Company’s performance) he or she requires to ensure that all members of the Board have the information they need to take sound decisions, monitor effectively and provide advice to promote the success of the Company .
The responsibility for the operational management of NV and PLC and the business enterprise connected therewith lies with the Group Chief Executive under the final and ultimate responsibility of the Board as a whole.
All employees are bound by Unilever’s Code of Business Principles which lay out broad rules for conducting business with the various stakeholders.
Unilever also appoints a Chairman whos primary responsibility is to ensure proper and effective functioning of the BoD. The Chairman is selected from the Non Executive Directors and elected by the boards. Like most global firms, institutioal investors hold more than 50% of the shares of the firm. All senior managers own ESOP’s to ensure goal congruence.
Thus we see that despite being a European firm, Unilever has adjusted to the Anglo-American system of corporate governance. It reflects a worldwide trend in which most firms are switching to the Anglo-American system of governance due to its emphasis on shareholder value first and foremost.
Kimberly Clark (KMB): While firms like P&G and Unilever prefer to separate management from the board, KMB prefers to link them with a common head. So we see Mr. Thomas J Falk as the Chairman of the board and CEO of KMB. Generally such an arrangement leads to conflict of interest between the BoD and the management. The reason is that since the CEO is also the Chairman of the Board, the board has significant lesser influence on the management or rather the management will find it easier to exert its influence on the board.
KMB is also different in that it has appointed a Lead Director from amongst its Directors. The Lead Director serves as the point of contact between the firm and the shareholders. The Lead Director is the Chairman of the Executive committee and is an ex-officio chairman of all standing committees. KMB too is majority owned by institutional investors with 51% in their hands. KMB too, like P&G and UL believes in ensuring goal congruence and eliminating agency problems by making all employees shareholders as well through their ESOP plan.
Like most corporations following the Anglo-American system of corporate governance, KMB too has a single tier structure. The CEO, reports to the board, who in turn advise him and the management team on strategic issues and policies.
The BoD as in P&G and Unilever is supported by various committees like the Audit Committee, the Management Development and Compensation Committee, and the Nominating and Corporate Governance Committee.
As is the case in P&G and Unilever, KMB board members have to qualify the “independent” criteria in order to get elected as a board member. Basically these are covenants which set financial limits to the stake one holds in KMB or restricts the kind of relation one has with a stakeholder of KMB in order to fulfill the conditions . All employees are governed by the Code of Conduct which like in the case of P&G and Unilever, lays down “broad” guidelines for conducting business with various stakeholders.
To value the various companies I have used the Triangulation Method.
In the Triangulation Method, I have attempted to estimate a range of share prices based on three methods of valuation: The APV (Adjusted present value) method, the DCF (discounted cash flow) method, and the transaction multiples method.
Each of the above mentioned methods gives a range of share prices. With the help of the Triangulation Method we are able to conduct a sensititivity analysis and thereby derive an optimal share price.
With the help of the transaction analysis method we are able to compare the P/E and the M/B values of key competitors, weigh them with sales and then compute an average value for the industry. Thus, we are able to get a relative share price for P&G w.r.t. the industry and not the whole S&P index.
Using the DCF method we are essentially valuing the free cash flows and calculating the intrinsic value of the share based upon the free cash flows and the PV of the horizon year. We are making some key assumptions with regards to the growth rates, horizon growth rates, change in working capital and PPE and also the cost of goods sold. Essentially we are basing our assumptions on the percentage of sales method. The APV method provides us the market value at the optimal capital structure (OCM) and recommends a price range based on the OCM and the current capital structure.
Procter & Gamble (P&G): P&G is the world’s largest consumer goods company with sales of $56b in 2005. P&G belongs to the FMCG (fast moving consumer goods) industry which is classified as a “classic growth” industry by the markets. The reason is that P&G produces commodity products which are used in daily everyday life. Growth in this industry is a function of population growth and inflation. Firms can differentiate only on brand differentiation, promotion and advertising.
P&G’s stock is undervalued. P&G has a beta of 0.76 . Thus P&G’s stock is negatively correlated to the S&P 500. Thus, in a bull run, P&G’s stock will not rise dramatically and during bearish period neither will it fall dramatically. P&G’s stock is a robust stock which is held by investors as a defensive holding which gives steady stable growth in earnings and dividends. This complements its 82% holding which is in the hands of institutional investors who seek a fixed income.
P&G, in the past few years has made a number of acquisitions in line with its strategy of expanding in the high growth beauty care segment. In 2005 it acquired Gillette for $57b. Investors are probably skeptical about the promised synergies and cost savings that the company has promised and have adopted a wait and watch attitude. I feel that once the promised benefits are delivered the market will correct the price to at least >15% – 20% of the current price. The market should also reward P&G’s lower risk profile after this acquisition. P&G is diversifying its product, market and customer portfolio to reduce its business risk.
Colgate Palmolive (CP): CP also belongs to the mature growth FMCG sector. Like P&G, it too reports robust growth year on year. CL too has an undervalued share price in the market. The reasons are similar to P&G’s. CL too has made some high profile acquisitions and the market is awaiting some positive benefits from the synergies and cost reductions promised. CL too is moving into high margin products and through its acquisitions is trying to achieve synergies and economies of scale. CL has a beta of 0.66, even lower than P&G’s. Thus, during a bull run, this stock will not rise dramatically and correspondingly during a bearish period, this stock will still give good returns. So, it is also a good defensive buy for the average investor. Institutional investors hold 61% of CL stock and demand regular fixed income returns. CL has also launched an ambitious restructuring program in 2004. I feel, like P&G, this stock too will rise by at least 15% – 20% once its promised benefits and sales growth is achieved.
Unilever (UL): UL has been plagued with stagnating growth since the last few years. In the past few years, UL has acquired only one firm in 2000 but has been selling off mostly its non core, non performing assets. Its Beta is only 0.59. Thus, UL is a defensive, steady stock which pays its shareholders steady dividends year on year. It is negatively correlated to the S&P 500.
I feel, the market is awaiting positive benefits from its divestments. Unilever has sold almost 30 businesses in the last few years. Once these benefits are achieved in terms of better profitability and reduction of losses from the non core businesses the price will correct.
Analysis of Various factors for the Industry
Industry Analysis of AFN:
I have calculated the AFN for competitors using the quick and dirty method only.
(Please refer Exhibit)
AFN = (A*/So)dS – (L*/So)dS – M.S1.RR
The sustainable growth rate for Unilever is 52.52%.
Unilever too has excess funds and therefore has no need for additional funds. Unilever has experienced falling revenues in 2005 and in the past shown growth rates of 4-5% only.
From the AFN formula, Colgate Palmolive too is not in the need for excess funds. Sustainable growth rate for CL is a whooping 79%.
The reason for the high sustainable growth rate for the industry is twofold. The industry is very low on debt with average debt ratios at 12% only. The steady growth in income contributes to high ROE while the mature nature of the industry ensures that even after paying out dividends, the firms have retained enough to fund growth via internally generated funds. Thus, the industry not only has no need for additional funds, but generates positive free cash flows which it uses to maintain steady growth in dividends and fund growth.
Analysis of AFN: An additional funds needed (or AFN) model estimates future financing requirements given a projected increase in revenue or sales. AFN models require that you make a number of assumptions concerning such variables as net profit margin, dividend payout, asset turnover, and the future use spontaneous liabilities. The accuracy of the forecast, of course, is based on the accuracy of your assumptions. Another obvious limitation of AFN models is they don’t identify where the company should obtain its additional financing. Using the AFN as a base method we can then run sensitivity analysis to determine which variables are most sensitive to changes.
Despite its limitations, the AFN model at least gives the analyst a rough idea of the need for additional funding.
Industry Acquisition summary: In all cases we see that the idea is to create offerings that complement each other and to achieve economies of scale. While in the stable market segments where most of the products are commoditized hence we see the trend for consolidation and synergy. All the firms seek to acquire brands that are high margin players. This balances their existing mass retail high volume low margin brands with the new low volume high margin brands.
I have also noticed that all the firms are gaining entry in the high margin medical devices segment. This segment of the health care industry is the fastest growing in recent years and has hence attracted the attention of FMCG giants who seek to leverage and complement their existing health care products
Most of the firms are trying to acquire or collaborate in order to expand geographically or enter segments in which they had no presence earlier.
Changes in the demographic profile of users across the world are driving their thrust into the medical devices market. As disposable incomes rise and people become more health conscious and ready to pay for good medical products, these FMCG firms will continue to expand their product offerings. In developing countries, which have a younger population the thrust towards attractive gadgets is driving sales for P&G.
All the firms in the FMCG industry are shifting production bases to the BRIC countries and are thus trying to reduce their supply chain management costs by acquiring products which can complement and be carried on the existing supply chain.
Analysis of Industry FRICTO: In general, the industry is classified as “classic growth” by the markets. The products of this industry are commoditized and used daily in various activities. Growth in this industry is a function of growth in population, advertising and promotional expenses. The industry is experiencing consolidation with the major players acquiring the smaller niche players to increase their footprint and increase margins through growth in the higher margin products.
The industry has a low dependence on debt. All the firms are able to run daily operations as well as fund majority funding in acquisitions through internally generated cash flows. All the firms maintain a high dividend payout ratio. Thus, all firms enjoy AA or higher bond rating in the market. This enables all the firms to have a high degree of flexibility should the need for additional extraordinary funds arise.
The industry like other firms in other industries faces rising oil prices and raw material costs. All the firms have a high dependence on Wal*Mart and other major retailers. They are trying to reduce this dependence by balancing and expanding into broader markets, products and customers. The Beta of all firms is lower than 1 signifying the markets belief in the low risk that these firms carry. The firms face problems with imitators and copyright violators leading to the firms filing lawsuits for infringement. The verdict of these lawsuits is unpredictable and may last several years. Since all the firms have significant foreign presence they face the need to hedge their foreign currency risk also. All the firms face strong competition from private labels in the powerful retail chains. The balance of power has changed from the hands of the marketer to retailers like Wal*Mart, Target, K-Mart, Carrefour and other hypermarts and malls. Thus, countering the power of the retailers to push their own private labels and balancing that with their own products is a tough challenge that the industry faces.
The firms should lower standard deviation in key parameters like growth in operating cash flows, EBIT and EPS as compared to other industries. This is again a reflection of the stable mature growth industry that the FMCG sector is.
Typical to any American firm, the firms are controlled by institutional investors who control > 50% of the firms. Thus, individual shareholders rather than any significant owner or a chunk of owners call the shots.
The world economy is buoyant, with the BRIC countries leading the growth. All the firms face high growth in the year ahead. However given their ability to utilize internally generated funds i.e. retained earnings, free cash flows and supplier’s capital, they really don’t need to issue additional debt.
Analysis of Industry Profit sharing policy for all stakeholders: We see that all the firms in the FMCG industry have a relatively stable dividend payout policy. The firms also have an increasing rate of payment since the last 3 decades or more. These firms have exhibited robust growth in revenues and earnings over the past several decades. This is partly due to the fact that these firms produce commodity products which are used everyday. The only way to differentiate these products is through branding. The firms have a majority ownership of mutual funds and institutional investors. These investors are middle aged, middle incomes who rely on the fixed dividend as a means of income. The firms have adopted a conservative profile in paying out dividends. They have deliberately kept the payout ratio low initially so that over the years they can increase the amount in increments of 10% thus sending positive signals to the market about their ability to pay dividends. Firms in this industry have had to regularly split their dividends to maintain the stock price within the “normal” range. Firms like KMB and CL have also arranged for share repurchases as a means to control their target capital structure. All the firms in the industry reward employees with generous stock option packages. Most of the firms have now initiated the ESOP package for lower ranked employees as well, instead of firms in other industry where firms have included the ESOP package for only senior employees. The firms have tried to achieve economies of scale by acquiring complementary brands and then combining the distribution and manufacturing to reduce costs. Thus the firms have partnered with suppliers to reduce costs and improve productivity, the benefits of which have been passed on to the customer. Finally, all firms are responsible citizens of the world with active corporate social initiatives headed by a Chief Corporate Social Development Officer. The firms undertake projects with children, women and the underprivileged in the countries of operation in areas of education, health and rural entrepreneurship.
Corporate Governance in the Industry: Overall, I see the industry regardless of whether it is an American Corporation –P&G, KMB- or a European – Unilever- follows the Anglo-American system of corporate governance. This method, with is emphasis on shareholder benefits first and foremost is the most popular system of governance. The firms in the industry are majority owned by institutional investors with more than 51% owned by that group. While this group singularly does not own more than 1% due to government regulations, as a group they have common interests and hence are able to influence the BoD with the help of proxy statements and shareholder action committees.
All firms are governed by a BoD, or board of directors. The CEO, reports to this BoD, who in turn are held responsible to the shareholders. The BoD generally is independent of the management except in case of KMB. The CEO, who represents the management, is supposed to provide the BoD with all necessary and relevant information to enable the BoD to take proper and effective action. P&G and UL have separated the board from management to ensure unbiased reporting whereas KMB prefers to keep the Chairman of the Board and the CEO as the same person.
All firms have set stringent guidelines for selection and continuation of the BoD. The guidelines are meant to ensure that the board maintains its integrity as an independent and unbiased objective body. In all firms, the BoD is assisted by several committees, the function of which is to assist the BoD in governing the firm. These committees ensure the right safeguards are in place and thus provide and incentive to work as per the proper guidelines issued in the Code of Conduct. All firms adhere to a Code of Conduct which defines “broad” guidelines on the proper conduct of business and transactions with various stakeholders.
Thus, we see that the firms in the industry have set effective controls, mechanisms and safeguards to ensure proper governance by the BoD. The end goal of these mechanisms and safeguards is to protect the rights of the small and ordinary shareholder by injecting accountability in the system and ensuring a goal congruence with managers and owners. All firms have instituted ESOP’s which make managers co-owners and hence ensure goal congruence and reduce agency problems.
Industry Analysis of Share Price Valuation: We see that most stocks in th