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working paper, 1997.
5. There is an important difference between the way ROE is de¬ned in the value-to-book formu-
lation and the way it is de¬ned in Chapter 9. The valuation formula de¬nes ROE as return on begin-
ning equity, whereas in our ratio discussion we used return on ending or return on average equity.
6. It may seem surprising that one can estimate value with no explicit attention to two of the
cash ¬‚ow streams considered in DCF analysis: investments in working capital and capital expen-
ditures. The accounting-based technique recognizes that these investments cannot possibly con-
tribute to value without impacting abnormal earnings, and that therefore only their earnings
impacts need be considered. For example, the bene¬t of an increase in inventory turnover surfaces
in terms of its impact on ROE (and thus, abnormal earnings), without the need to consider explic-
itly the cash ¬‚ow impacts involved.
7. It is also possible to include a drift term in the model, allowing earnings to grow by a con-
stant amount, or at a constant rate each period.
Prospective Analysis: Valuation Theory and Concepts

11-23 Part 2 Business Analysis and Valuation Tools

8. See P. M. Dechow, A. P. Hutton, and R. G. Sloan, “An empirical assessment of the residual
income valuation model,” Journal of Accounting and Economics 23, January 1999.
9. This formulation is a variant of a model proposed by James Ohlson, “Earnings, book values,
and dividends in security valuation,” Contemporary Accounting Research 11, Spring 1995. Ohl-
son includes in his forecasts of future abnormal earnings a variable that re¬‚ects relevant informa-
tion other than current abnormal earnings. This variable then also appears in the stock valuation
formula. Empirical research by Dechow, Hutton, and Sloan indicates that ¬nancial analysts™ fore-
casts of abnormal earnings do re¬‚ect considerable information other than current abnormal earn-
ings, and that this information is useful for valuation.
10. This speci¬cation is similar to the model for dividends developed by J. Lintner, “Distribu-
tion of incomes of corporations among dividends, retained earnings, and taxes,” American Eco-
nomic Review 46 (May 1956): 97“113.
11. In practice, ¬rms do not have to pay out all of their free cash ¬‚ows as dividends; they can
retain surplus cash in the business. The conditions under which a ¬rm™s dividend decision affects
its value are discussed by M. H. Miller and F. Modigliani in “Dividend Policy, Growth and the
Valuation of Shares,” Journal of Business 34 (October 1961): 411“433.
12. A good forecast, however, would be grounded in an understanding of these changes as well
as all other key elements of the ¬rm™s ¬nancial picture. The changes in ¬nancing cash ¬‚ows are
particularly critical for ¬rms that anticipate changing their capital structure.
13. Unbiased accounting is that which, in a competitive equilibrium, produces an expected
ROE equal to the cost of capital. The actual ROE thus reveals the presence of economic rents. Mar-
ket-value accounting is a special case of unbiased accounting that produces an expected ROE equal
to the cost of capital, even when the ¬rm is not in a competitive equilibrium. That is, market-value
accounting re¬‚ects the present value of future economic rents in book value, driving the expected
ROEs to a normal level. For a discussion of unbiased and biased accounting, see G. Feltham and
J. Ohlson, “Valuation and Clean Surplus Accounting for Operating and Financial Activities,” Con-
temporary Accounting Research 11, No. 2 (Spring 1995): 689“731.
14. In his book on EVA valuation, Bennett Stewart (1994) recommends a number of accounting
adjustments, including the capitalization of research and development.
15. S. Penman and T. Sougiannis, “A Comparison of Dividend, Cash Flow, and Earnings Ap-
proaches to Equity Valuation,” The Accounting Review, compares the valuation methods using ac-
tual realizations of earnings, cash ¬‚ows, and dividends to estimate prices. J. Francis, P. Olsson,
and D. Oswald, “Comparing Accuracy and Explainability of Dividend, Free Cash Flow and Ab-
normal Earnings Equity Valuation Models,” 1997, University of Chicago working paper, estimates
values using Value Line forecasts.
Schneider and Square D

Inlate January 1991, Didier Pineau-Valencienne, CEO and Chairman of
the French ¬rm Groupe Schneider, was frustrated at his lack of success in building a
closer working relationship between his company and Square D, Schneider™s American
counterpart in the electrical equipment industry. Convinced that a global market was de-
veloping for electrical equipment, Pineau-Valencienne believed that Schneider needed
Business Analysis and Valuation Tools

to become a major player in the U.S. market to maintain its future competitive position.
Given the lack of success in partnering with Square D, he was considering the option of
acquiring the company.

11 The electrical equipment industry generates revenue from new construction as well as
Prospective Analysis: Valuation Theory
from the maintenance of existing equipment. Demand for both closely follows general
and Concepts

economic conditions. The 1990 economic slump hit the electrical manufacturing seg-
ment in the United States severely. However, by early 1991 analysts expected prospects
for the industry to brighten with the predicted upturn in the economy and the construc-
tion market.
Two related trends dominated the industry in 1990: globalization and industry con-
centration. The ¬rst of these has led many U.S. ¬rms to expand internationally to take
advantage of market growth in Western Europe and Paci¬c Rim countries. These inter-
national opportunities have been enhanced by the globalization of product standards in
the industry. The most widely accepted standards in the U.S. were developed by the Na-
tional Electrical Manufacturers Association (NEMA). European products conformed to
a different set of standards, developed by the International Electrical Commission (IEC)
in Geneva. However, many in the industry expected that the move toward a uni¬ed Eu-
rope, set for 1992, would ultimately lead IEC standards to become dominant in the
The second major trend in the industry, concentration of manufacturing and research
capabilities, resulted from increasing costs of development and production as well as
from globalization. The development of a new product line costs between $46 million

This case was prepared by Edouard De Vitry D™Avaucourt, under the supervision of Professor Paul Healy.
Additional comments and information were provided by Professors Paul Asquith from the MIT Sloan School of
Management and Anant Sundaram from the Amos Tuck School.

Prospective Analysis: Valuation Theory and Concepts

11-25 Part 2 Business Analysis and Valuation Tools

and $74 million (FF 250 million to FF 400 million). Globalization of markets and prod-
uct standards enabled ¬rms to take advantage of economies of scale, using their exper-
tise and technologies to create common products for domestic and international markets.

Square D is a major supplier of electrical equipment, services, and systems in the U.S.
Schneider and Square D

(see Exhibit 1 for Square D™s U.S. market shares). The company was incorporated in
1903 and has grown steadily since then. It currently owns and operates 18 manufacturing
plants in 11 foreign countries. Operations are concentrated in two segments: electrical
distribution and industrial control. The electrical distribution segment manufactures
products and systems used to transmit electricity from power lines to outlets for residen-
tial, commercial, industrial, or other types of buildings. The industrial control segment
manufactures products and provides services to control power used by electrical devices
or processes.
One of Square D™s strengths is its network of independent electrical distributors, or
wholesalers, which market its products. Individual distributors, selected by Square D,
provide products and services to all types of clients (contractors, utilities, industrial us-
ers, and original equipment manufacturers). This extensive network is the result of many
years of relationship building, and is the envy of most of Square D™s competitors.
Square D™s major competitors include ABB, Westinghouse, Siemens, Allen Bradley,
General Electric, and Schneider (through its subsidiaries T©l©m©canique and Merlin
Gerin). These companies compete across a number of segments. In late 1990, US Indus-
trial Outlook ranked Square D second in the U.S. industrial control business after Allen
Bradley. In electrical distribution, the company ranks third in the U.S. market behind
Westinghouse and General Electric.
Square D has had an impressive ¬nancial track record”it has been pro¬table for each
of the last 59 years. In the mid-1980s, however, company performance indicators began
to deteriorate, prompting the Board to make a change in top management. Jerre Stead
joined Square D as president and COO in 1987, was elected CEO in 1988, and was ap-
pointed Chairman of the Board in 1989. Stead led a revitalization plan to restore the
company™s performance and help it face the new industry challenges. Under the plan the
following restructuring changes were made:
• Some facilities in the U.S. and Canada were closed, and others were consolidated.
• The firm™s businesses were reorganized into three externally focused sectors serv-
ing industrial control, electrical distribution, and international markets.
• The resources generated by redeployments and disposal of operations not closely
related to the core were used to strengthen core businesses.
Thanks to these efforts, Square D weathered the 1990 recession better than many of
its competitors. In 1990 Square D™s sales were $1.7 billion (see Exhibit 2 for ¬nancial
statements), 71 percent in the electrical distribution segment (85 percent of operating
430 Prospective Analysis: Valuation Theory and Concepts

Prospective Analysis: Valuation Theory and Concepts

earnings) and 29 percent in the industrial control segment (15 percent of operating earn-
ings). By early 1991 analysts were expressing optimism about the industry™s prospects
for late 1991 and 1992, especially those for Square D. Value Line noted that “a stronger
economy, a rebound in housing, and positive operating leverage . . . could enable earn-
ings per share to surge to $5.50 or so in 1992 (from $4.73 in 1990).”


Schneider and Square D
Schneider was founded in October 1886 as a partnership and was transformed into a cor-
poration (soci©t© anonyme) in 1966. It is one of the largest industrial groups in France
and is ranked 184 in Fortune™s 500 (worldwide ranking).
In 1981, with the arrival of Pineau-Valencienne as chairman and CEO of the group,
Schneider embarked on an ambitious restructuring program. The ¬rst stage of the pro-
gram was to divest all loss-making businesses (shipbuilding, railways, and telephone
equipment), which had historically generated much of the ¬rm™s sales. The sale of these
businesses allowed the group to simplify its operational structure and to strengthen its
¬nances. In the second stage of the restructuring Schneider focused on two core busi-
• Electrical equipment manufacturing for power distribution and automation of in-
dustrial complexes (56 percent of sales, 85 percent of operating profits in 1990)
• Electrical building contracting (44 percent of sales, 15 percent of operating profits
in 1990)
As a result of the restructuring efforts, Schneider transformed itself from a diversi¬ed
holding company into an industrial group focused on electrical equipment, engineering,
and contracting. The company was organized around four major industrial subsidiaries:
• Merlin Gerin”Manufacturer of high-, medium-, and low-voltage equipment, as
well as process control systems
• T©l©m©canique”Manufacturer of automation systems and equipment
• Jeumont Schneider”Manufacturer of electrical and electronic engineering equip-
• Spie Batignolles”Provider of electrical contracting and civil engineering services
With sales of 51 billion francs (¬nancial statements are presented in Exhibit 3) and
85,000 employees throughout the world in 1990, Schneider ranked second or third in
most segments of the global electrical equipment industry.
In the late 1980s, Pineau-Valencienne became convinced that the industry was mov-
ing more toward a global industry. In his communications with analysts, he emphasized
that IEC standards would gain in¬‚uence in the U.S. and would become the worldwide
standard. In addition, he believed that increasing R&D and manufacturing costs would
encourage international concentration. Consequently, Schneider began a third restruc-
turing stage”geographical diversi¬cation. This move was initiated with two major
acquisitions in 1989:
Prospective Analysis: Valuation Theory and Concepts

11-27 Part 2 Business Analysis and Valuation Tools

• Spie Batignolles acquired 15 percent of DAVY, the leading British engineering
• Schneider acquired a controlling interest in Federal Pioneer, the leading Canadian
electrical equipment manufacturer.

The Relationship Between Schneider and Square D
Schneider and Square D

Schneider became interested in Square D in 1988. In September 1988, Pineau-Valen-
cienne arranged a meeting between the top executives of the two companies, during
which Schneider presented its vision of a possible joint venture. After this presentation,
operational meetings were scheduled from fall 1988 to spring 1989 to determine the
product lines most suitable for such a joint venture. To protect the information ex-
changed, the companies entered into a con¬dentiality agreement in late October 1988.
This restricted the use and public disclosure of con¬dential information received during
the discussions, but it did not contain any “standstill” provisions limiting purchase of se-
curities or business combination proposals.
Very early in the negotiations it became clear that the two CEOs diverged in their un-
derstanding of the nature of the relationship. Pineau-Valencienne had hoped that
Schneider would acquire an equity position in Square D to cement the relationship.
Stead, however, made it very clear that he did not welcome this, and requested that
Square D™s independence be respected. In correspondence on September 25, 1989,
Pineau-Valencienne made his views very clear, connecting the future of the joint venture
discussions to Square D™s agreeing to Schneider acquiring a 20 percent interest in
Square D. As a result, joint venture discussions between the two ¬rms terminated. Frus-
trated over this standstill, in September 1990 Pineau-Valencienne indicated to Stead that
Schneider™s interests in Square D had changed from a joint venture to a “friendly cash
merger transaction.” Square D™s Board subsequently became increasingly hostile to
Schneider™s proposals.


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