|Kimberly-Clark Corporation (KMB)
Solution to Continuing Case, Chapter 2
THE FORM AND CONTENT OF KIMBERLY-CLARK’S FINANCIAL STATEMENTS
Applying accounting relations for 2010 (Amounts in millions)
Balance sheet equation 2.1: Balancing the balance sheet
Shareholders’ equity = Assets – Liabilities
$6,202 = $19,864 ‒ $13,662
Liabilities are current liabilities plus long-term liabilities. The balance sheet does not report the total—the reader must do the totaling. Note that GAAP requires redeemable preferred stock to be classified outside shareholders’ equity – in what is called a mezzanine. This preferred stock has been included as a liability in the calculation above (as indeed it is from a common shareholders’ point of view).
Common shareholders’ equity of $5,917 million is total equity of $6,202 million less noncontrolling interests of $285 million.
Income statement equation 2.2a: How we get to the “bottom line.”
Equation 2.2a works as follows:
Cost of sales 13,196
Gross margin 6,550
Share of income in equity companies 181
Other income (expense) (104)
Operating expenses 3,673
Net interest expense 223
Income before taxes 2,731
Tax expense 788
Income before extraordinary items 1,943
Income from discontinued operations -
Income before noncontrolling interest 1,943
Noncontrolling interest 100
Net income 1,843
The categories in equation 2.2a in the text are typical ones, but don’t apply to all firms. The above adapts to Kimberly-Clark’s format. We have included “share of income in equity companies” above ebit so that ebit (appropriately) includes this item.
Cash flow statement equation 2.3: Explaining the change in cash
Cash from operations $2,744
Cash investment ( 781)
Cash used for financing (1,859)
Change in cash before exchange rate effects 104
Statement of shareholders’ equity equation 2.4:
There are two equity numbers, total equity (that includes noncontrolling interest) and common shareholders’ equity (exclusive of this minority interest). As we wish to value the common equity in this book we need to separate the common equity from the minority’s equity. So apply equation 2.4 to track how the common equity changes over the period.
Comprehensive income to common = $2,210 (from the comprehensive income
Net payout = $1,699
Ending equity = $5,406 + 2,210 – 1,699
The beginning and ending equity for 2010 are in the balance sheet. These numbers are also the net sum of the beginning and ending balances (excluding noncontrolling interest) of the equity statement.
Net payout is common dividends + share repurchases – share issues, that is, everything else in the equity statement beside comprehensive income items:
Net payout (to common) = dividends + stock repurchases – share issues
$1,699 = $1,085 + 809 – 195
The share issues are the total of the net additions to Additional Paid-In Capital which includes a negative amount of $37 million for shares previously issued to employees as compensation but now forfeited (presumably because they did not vest). The forfeiture of shares by employees is treated as a negative share issue. Shares issued to employees of $170 million (probably in exercise of stock options) were issued out of Treasury. Note: the item, Recognition of Stock-based Compensation, is a strange animal that we will get to in Chapter 9. Why would compensation be an increase in shareholders’ equity? The answer is the odd treatment of employee stock options under FASB Statement 123R and IFRS 2.
Comprehensive income equation 2.5:
Comprehensive income to common = $1,843 + 367
Other comprehensive income (OCI) for the common shareholders is in the Statements of Stockholders’ Equity, made up as follows:
Foreign currency translation gain $ 326
Employee postretirement benefits 57
Other comprehensive income $ 367
Employee postretirement benefits are a gain from a program for employee benefits that must be reported in OCI rather than in the income statement. (See Accounting Clinic VII).
Telling the story
KMB began 2010 with $5,406 million in common shareholders’ equity, in the form of $19,209 million in assets net of $13,519 million in liabilities to other parties and a minority interest in subsidiaries of $284 million. During 2010 it earned $2,210 million in comprehensive income for common shareholders and paid out a net $1,699 million to these shareholders, most of it in the form of dividends and stock repurchases, net of some small share issues, leaving $5,917 million in common shareholders’ equity at the end of the year. That $5,917 was in the form of assets of $19,864 million less liabilities of $13,662 million of which minority shareholders had an interest of $285 million.
In carrying out its business, KMB increased its cash by $104million (before the effect of exchange rates on the dollar value of cash), with $2,744 million coming from operations, $781 million applied to investments, and $1,859 used for net payments to shareholders and debtholders.
Assets and liabilities close to fair value
Think of fair value as the amount you would be willing to pay for an asset (or would pay someone else to relieve you of the liability).
Here are items that would be close to that:
Cash and cash equivalents
Accounts receivable (if allowances are calculated in an unbiased way)
Long-term debt and debt payable within one year (close to fair value unless interest rates or credit quality have changed a lot since the debt was issued)
Most current liabilities (unless accrued liabilities are not estimated appropriately)
All other items are at historical cost, amortized, depreciated, or (possibly) written down for impairment in some cases.
Note that equity investments in the balance sheet are those under the “equity method” not the mark-to-market kind. These are the investments that produce the “Share of net income in equity companies” in the income statement. See Accounting Clinics III and V (on the web page) for the treatment of different forms of equity investments.
The big missing asset for Kimberly-Clark is its brand asset. This firm has many well-known brands (listed in the Chapter 1 case) which will earn it continuing profits in the future. Its distribution network and claim on retail shelf space is also an asset.
Proper matching recognizes expenses incurred to generate the reported revenues. It says, “here is the value given up to earn the revenues.” Mismatching fails to do this. Mismatching tends to get worse as you move down the income statement. The match of revenue to cost of goods sold usually works well. But nothing stands out for KMB as particularly bad matching, with the exception of advertising and R&D.
Advertising is incurred to generate future sales but, as it must be expensed immediately under GAAP, it is (mis)matched with current sales revenue: More advertising creates future income but reduces current income so current income may not be a good indication of the future. (Note, however, that if advertising expenditures are constant -- that is, not growing -- advertising expense is the same in the income statement irrespective of whether it is capitalized and amortized or expensed immediately; growing advertising expenditures depress income and slowing advertising expenditures inflate income.)
KMB has some research and development (included in “Marketing, research, and general expenses”) and these, like advertising involve mismatching. R&D expenditures are expensed immediately but are made to generate future sales, not current sales. Increasing R&D investments adds value (typically) but decreases income, and a firm can increase its income by reducing R&D.
MARKET VALUES AND MARKET MULTIPLES
Total market value of common equity (sometime called “market capitalization”)
= Price per share × Shares outstanding
= $65.24 × 406.9 million
= $26,546 million
Note: shares outstanding are issued shares (478.6 million) less shares in treasury (71.7 million). These numbers are given in the equity section of the balance sheet and also on the bottom line of the equity statement. Treasury shares are issued shares that have been repurchased, so are not outstanding.
Premium over book value = $26,546 - $5,917
= $20,629 million
P/B ratio = $26,546/5,917 = 4.49
The P/B ratio can also be calculated with per-share numbers as
P/B = $65.24/$14.54 = 4.49
Where $14.54 = $5,917/406.9 is book value per share
A P/B ratio of 4.49 indicates that the market thinks there is a lot of value that is not on the balance sheet. This is not unusual for a brand company, for the value of the brands is not booked to the balance sheet.
P/E = $26,546/$2,210 = 12.01
This P/E is based on comprehensive income. Based on earnings per share (as in more common),
P/E = $65.24/$4.47 = 14.60 (Always use basic eps.)
In Chapter 3 you will see how the P/E ratio needs to be adjusted for dividends for valuation purposes:
Trailing P/E = (65.24 + 2.64)/4.47 = 15.19
The dividend adjustment in the numerator is made because dividends reduce price (in the numerator) but do not affect earnings. So this P/E is does not depend on dividends.
The P/E ratio indicates the market’s expectation of future growth in earnings over current earnings. A P/E of 15.19 is about in line with the average P/E for U.S. stocks over the years (see Fig. 2.2), so the market is expecting average growth for this firm.
We will get far more insights into the P/B and P/E when we come to Chapters 5 and 6.
Usually, enterprise vale is calculated as:
Value of the firm (enterprise) = Value of the equity + Value of debt
However, there is also a minority (noncontrolling) interest in the enterprise here, so:
Value of the firm (enterprise) = Value of the equity + Value of debt + Value of the
= $26,546 + $5,050 + $1,280
Where did the debt figure come from? Well, it is net debt, that is, debt minus any interest-bearing assets, with preferred stock being treated as debt. Interest-bearing assets are not part of the business (the enterprise). They are just investments of excess cash.
Debt payable within one year $ 344
Preferred securities of sub 506
Long-term debt $5,120
Preferred stock 541
Cash equivalents 850
Short-term note receivable 218
Long-term note receivable 393 1,461
Net debt $5,050
It is usual to take this book value of net debt as approximately its market value. This will be incorrect only if the value of debt has changed significantly since it was issued, either due to changes in interest rates or changes in credit quality. Preferred stock is debt from the common shareholders’ point of view. Cash equivalents (earning interest) are estimated at $850 million, with the remainder of the $876 million “cash and cash equivalents” being operating cash used in the business. The notes receivable are also interest bearing debt—see Footnote 2 in the 10-K.
“What is debt” versus assets and liabilities used in the business will be covered in Chapter 10. Note that the liabilities other than the debt included here are liabilities of the enterprise to those who supply the business, not liabilities that the enterprise owes to debtholders who finance the business. Again, this will become clearer later.
Where did the value of the minority interest come from? This is estimated at 4.49 times the book value of $285 million, where 4.49 is the P/B ratio calculated earlier.