Thursday, November 13, 2008

Nike Case

We recommend a buy for Nike's stock on July 6, 2001. Our analysis consists of a discounted cash flows model. We projected unlevered free cash flows over the next 10 years and discounted them according to our derivation of Nike's weighted average cost of capital. Our analysis suggests the stock is significantly undervalued, given our expectation it will deliver earnings in the future.

Below we have analyzed Joanna Cohen's WACC calculation and her projection of cash flows. We then calculate our own WACC, discuss the results of our own model for cash flow projections, and conclude with our valuation and notes regarding our recommendation.

Evaluation of Joanna Cohen's WACC Calculation

Cohen's WACC calculation is decent, but has a few issues, and a number of errors, as described below.

  • Weighting the capital structure. She weights the capital structure using the book value of equity. Nike is a public company, and its market capitalization is a more relevant metric for equity than the book value of equity.

  • Cost of debt. To calculate the cost of debt, Cohen simply divides the interest expense by the average balance of the interest-bearing debt. This is an approximation for the true cost of the debt, but is too inaccurate. The interest expense line may include expenses not directly related to the debt of the company (unlikely, but perhaps non-cash payment-in-kind expenses for the preferred stock, or simply interest expense recognized under GAAP, but not necessarily indicative of real costs of debt).
    The cost of debt should include the current market yield on Nike's publicly traded debt, as this is a more pertinent metric.

    Furthermore, Cohen uses the 20 year yield on treasury bonds to approximate the risk free rate. We feel that the 3-month yield on treasuries is appropriate.

  • Market premium. Cohen uses a market premium of 5.9%, which is surprisingly low. She claims it is the market performance in excess of the treasury rate, but fails to defend this assertion. Perhaps using the arithmetic mean is a better approximation than the geometric mean for the market risk premium.

  • Decision to use only one WACC. She divided each division by revenue. In deciding whether to use an overall WACC, or to assign a WACC to each division, she should have weighted each division by cash flows, and not by revenue. It is reasonable to ignore the other sports division, as it is such a small fraction, but perhaps it would have been wise to calculate different WACC's for the footwear and apparel divisions. However, her evaluation of risk related to each division is a defensible one in using a single WACC for the entire company, and we view this as a potential issue, but not as an error per se.

  • Cost of Japanese debt. The risk related to Japanese debt comes not only from interest rate risk, but also more significantly from foreign currency exposure. This risk has not been accounted for and is actually a more potent risk to the debt than fluctuations in the yield to maturity.

  • Tax benefit of interest expense related to Japanese debt. Under U.S. tax law, interest expense on non-dollar-denominated debt is not a tax-deductible expense, and thus these notes should not be tax-effected (our analysis, however, remains within the scope of this class and tax-effects the yield to maturity).

Evaluation of Joanna Cohen's Cash Flow Projections
Overall, her projections seem fairly sound. She keeps margins fairly consistent, with only slight variations. Revenue growth projections are modest, and the firm seems decent cash requirements. However, there are a few issues with her projections.

  • Revenue growth projections. Company executives indicated a long-term revenue growth target of 8% to 10% and earnings growth targets of above 15%. Why has she cut her projections? We do not consider her move unreasonable, but we are interested to hear why she did this.

  • Capital expenditures and depreciation. She projects depreciation and capital expenditures as equal in the future. It is unlikely, considering the projected growth rates, that Nike could grow without increasing capital expenditures. Looking at their historic financial statements, capital expenditures far outweighed depreciation and amortization, and so Cohen has made the mistake of understating cash requirements related to fixed costs. (See appendix 1 for our projection of capital expenditures and depreciation.)

  • Positive cash requirement for net working capital. In her first year's projection, she shows a cash inflow of $8.8 million related to working capital. Where does this come from, and why does it occur? Historically, her working capital requirements have been consistently negative, and since she projects the company to grow, we expect the company to use cash in working capital.

  • Equity value calculation. The calculation of enterprise value to equity value only removes total debt. It should remove net debt and preferred stock, and so has understated equity value.

  • Shares outstanding. Her figure for shares outstanding does not match the diluted share count on the income statement, nor does it match the common shares outstanding (when net income is divided by common EPS).

  • Cash flow recognition method. She assumes an end-point method for recognizing cash flows. While this is not uncommon, it is also probably not appropriate, as Nike receives cash flows throughout each period, and thus should recognize the cash flows using a mid-point method.

WACC Calculation
See appendix 4 for full details of our WACC calculation. We calculated the cost of debt using the yield to maturity, considering an upcoming coupon payment is about to be made. Our cost of equity followed the capital asset pricing model, and the two costs were weighted by their levels within the capital structure, using market valuations in weighting the equity value.

In the attached appendices, we calculated our own WACC and projected cash flows, duplicating Cohen's analysis but with corrections as we saw fit (described above). In the appendix, we projected future capital expenditures and depreciation, as we did not agree with Cohen's assertion that capital expenditures will equal depreciation. We then discount the new cash flows subject to new, but similar, criteria, and arrive at an enterprise value. Finally, we calculate an equity value and produce a similar sensitivity chart as shown before.

The model in the appendices employs methods that correct those used by Cohen. We re-projected capital expenditures and depreciation to be more accurate (as appendix 1 demonstrates) and tweaked the discounting methods, as described in the above sections.

Our analysis, in appendix 3, shows equity prices per share at various discount rates. Most values are above the current share price of $42.09. Our chosen discount rate of 9.09% yields a share price of $61.44, or a current under-valuation of the stock of $19.35 (46%) per share. The discount rate that yields no over- or under-valuation (the current price per share) is 11.41% – significantly higher than our discount rate of 9.09%.

Since the date of the case, Nike's stock rose sharply in the following 9 months, proceeded to drop back down to similar levels after 1 year, and continued to grow significantly thereafter. However, in recent months (2008), it has come down. The short run (after the case) validates our analysis somewhat, however, it is extraordinarily difficult to identify a time period that represents the point at which we agree whether a valuation was "correct" or 'incorrect" (and of course, it is also very difficult to identify what constitutes a correct valuation in the first place).

Appendix -


  1. For once write something that I understand..!!!!

  2. Thanks for posting this- gave me some ideas for the same assignment.

  3. where's appendix 4 ??????????

  4. How did you discount the long term debt?

  5. @Ericaa: We calculated the cost of debt using the yield to maturity, considering an upcoming coupon payment is about to be made. If you download the appendix the calculation should be there

  6. thanks for your is so clear and simple to understand. but I also failed to find appendix 2-4 in your blog ( I can only dl appendix 1 regarding cash flow calculation). maybe, if possible, could you please also upload appendix 2-4 for detailed calculation on WACC, COD and COE.
    Thanks a lot =)

  7. good point Nargiz....

    only appendix 1 is up, so I can't really follow all the calculations.. but I'll take his word for it.

    This is one of the better versions of this case :)

    can you post the rest of the calculations?

  8. @Camelia and @ Tatyana: The older appendix actually had everything its only that everything was numbered as Appendix 1. Since all the comments repeatedly ask for it. I have corrected for this problem now.

    1. @ Abhikush, your analysis is very interesting but i'm not able to find the mentioned appendix as they are not anymore on the previous location. Can you please share them once again if you still having them.

  9. Hi, I'm an MBA student of Helsinki school's Seoul campus. My name is Lily. Thanks for your sharing this analysis, it's very sweet.
    If I could, may I ask a question? Why do you think 3-month yield on treasuries is appropriate?

  10. @lily: When I was doing it, I thought it is better to get the true risk-free rate as longer treasuries still have inflation risk embedded in them. But I think it is better to use 10-year treasury in this case. However, when I did it the spread between 3-month and 10-year was not too high.

  11. im a few years late :0) but your appendices are no longer avaialable?