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Extensive summary - Valuation: Measuring and Managing the Value of Companies 7th Edition Part 1-2
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Notes / Aantekeningen Value based management (EBM160A05)
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Corporate Valuation for MSc Finance Summary 2022-2023
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Valuation 7ePart 1: Foundations of Value
1. Why Value Value?
The guiding principle of value creation is that companies create value by investing capital they raise from investors to generate
future cash flows at rates of return exceeding the cost of capital (the rate investors require to be paid for the use of their
capital). The faster companies can increase their revenues and deploy more capital at attractive rates of return, the more value
they create. The combination of growth and return on invested capital (ROIC) relative to its cost is what drives value. Companies
can sustain strong growth and high returns on invested capital only if they have a well-defined competitive advantage.
Competition tends to erode competitive advantages and, with them, ROIC.
Conservation of value = anything that doesn’t impact cash flows or risk, does not impact value.
Consequence of forgetting value principle are bubbles and financial crises, such as internet bubble of 1990s (unrealistic ROICs)
and financial crisis of 2008 (CDOs did not reduce risk).
This book is a guide to the economics of value creation and the process of measuring value.
Creating long-term value: don’t reduce investments in product development and quality to inflate short-term profits as
investments in R&D correlate powerfully with long-term shareholder returns. In order to create long-term value, companies
must continually seek and exploit new sources of competitive advantages.
2. Finance in a Nutshell
1. Companies create value when they earn a return on invested capital (ROIC) greater than their opportunity cost of capital.
2. If the ROIC is at or below the cost of capital, growth does not create value.
3. Companies should aim to find the combination of growth and ROIC that drives the highest DCF.
4. Performance in the stock market may differ from intrinsic value creation, as the market value depends on the market’s
expectations of future performance, which may be different from the companies’.
5. The returns that shareholders earn depend on changes in market expectations as much as on the actual performance of the
company. If the firm performs just as expected, the investors’ return will be just their opportunity cost i.e. WACC.
3. Fundamental Principles of Value Creation
Companies create value for their owners by investing cash now to generate more cash in the future. The amount of value they
create is the difference between cash inflows and the cost of the investments made, adjusted to reflect the fact that tomorrow’s
cash flows are worth less than today’s because of the time value of money and the riskiness of future cash flows.
The relationship of growth, ROIC, and cash flow
Growth = ROIC * Investment rate
Free cash flow = NOPAT * (1 – IR) = NOPAT * (1 – g / ROIC)
Free cash flow (FCF) = residual cash flow for investors once investments have been subtracted and the amount of reinvestments
are determined by the level of growth and ROIC
The conversion of revenues into cash flows is a function of a company’s return on invested capital (ROIC) and its revenue
growth. That means the amount of value a company creates is governed ultimately by its ROIC, revenue growth, and ability to
sustain both over time (competitive advantage).
Growth requires reinvestment in plant, equipment, or working capital. The more capital efficient a company is (higher ROIC), the
less it has to reinvest for a certain level of growth.
Higher growth rate reduces initial FCF, however after time the increase in invested capital through reinvestments generates
higher FCFs.
Value driver formula:
Equation shows that value is driven by growth, ROIC, and cost of capital (risk), assuming constant growth and ROIC.
Balancing ROIC and growth to create value
Matrix shows how different combinations of growth and ROIC translate into value:
1
,Improving ROIC, for any level of growth, always increases value because it reduces the investment required for growth. While,
increasing growth increases value only if a company’s ROIC is greater than its WACC. Growth at lower returns actually reduces a
company’s value. When ROIC equals WACC, growth has no impact on value.
Low ROIC in mature companies indicates a flawed business model or unattractive industry structure.
A company will create value only if its ROIC is greater than its cost of capital. Moreover, only if ROIC exceeds the cost of capital
will growth increase a company’s value.
Implications for managers
1. Companies already earning a high ROIC can generate more additional value by increasing their rate of growth, rather than
their ROIC. For their part, low- ROIC companies will generate relatively more value by focusing on increasing their ROIC.
2. Not all growth earns the same ROIC
Value created by different types of growth:
Growth strategies based on organic new-product development frequently have the highest returns because they don’t require
much new capital; companies can add new products to their existing factory lines and distribution systems. Furthermore, the
investments to produce new products are not all required at once. If preliminary results are not promising, future investments
can be scaled back or canceled.
Acquisitions, by contrast, require that the entire investment be made up front.
Growth by increasing competition has a negative effect on profitability which decreases value.
3. Method to improve ROIC: a company can increase ROIC by either improving profit margins or improving capital productivity.
ROIC = NOPAT / Sales * Sales / IC
2
,increase in ROIC through margin improvement will have a moderately higher impact on value relative to improving capital
productivity.
Example: firm with no growth improves profit margin which increase CFs every period, but improving capital efficiency increases
(e.g. reducing working capital) CFs one-time only in the current period.
Economic profit combines ROIC and size
Economic profit = IC * (ROIC – WACC)
Represents value created by a company in a single period
Conservation of value
Anything that doesn’t impact CFs, does not impact value, such as:
1. Share repurchases increase EPS but do not create value as total CFs do not change, but do increase leverage which increases
cost of equity
2. Acquisitions create value only when the combined CFs of the two companies increase due to cost reductions, accelerated
revenue growth, or better use of fixed and working capital.
3. Financial engineering do not create value if total risk has not changed
4. Risk and the Cost of Capital
4.1 Cost of capital is an opportunity cost
WACC incorporates both the time value of money and the risk of investment in a company, business unit, or project. The cost of
capital is not a cash cost, but an opportunity cost. The opportunity cost is based on what investors could earn by investing their
money elsewhere at the same level of risk.
Companies have little control over their cost of capital
Only undiversifiable risk affect the WACC as investors have the ability to diversify their portfolio and they require compensation
only for risks they cannot diversify away. In 2019, most large companies’ WACC fell in the range of 7% - 9%.
Furthermore, because non-diversifiable risk also generally affects all companies in the same industry in the same way, a
company’s industry is what primarily drives its cost of capital. Companies in the same industry will have similar costs of capital
through their beta.
Create better forecasts, not ad hoc risk premiums
Diversifiable risk should only be reflected in the cash flow forecast using multiple cash flow scenarios, not by applying
unjustifiable premiums in the WACC, which are often overestimated.
3
, Decide how much cash flow risk to take on
A company should take on all projects or growth opportunities that have positive expected values even if there is high likelihood
of failure, as long as the project is small enough that failure will not put the company in financial distress, i.e. can’t absorb the
loss. In practice, we’ve found that companies overweight the impact of losses from smaller projects, thereby missing value
creation opportunities.
Decide which types of risk to hedge
Companies should hedge only the risk which cannot be managed by the shareholders themselves and which are not part of the
core business, such as currency risk.
5. The Alchemy of Stock Market Performance
5.1 Why shareholder expectations become a treadmill
All the investors collectively will earn, on a time-weighted average, the same return as the company (ROIC). But individual
groups of investors will earn very different returns, because they pay different prices for the shares, based on their expectations
of future performance.
Expectation treadmill = firm beats expectations, stock price goes up, however, managers must ‘run’ even faster just to maintain
the new price.
Earning a high total shareholder return (TSR) is much harder for managers leading an already successful company than for those
leading a company with substantial room for improvement. A company performing above its peers will attract investors
expecting more of the same, pushing up the share price, which makes it very difficult to keep outperforming the market, i.e.
outperformance is already priced in. As long as a company delivers results in line with the market’s expectations, its share price
performance will be no better or worse than average (its TSR = cost of equity)
Managers of companies with low performance expectations might easily earn a high TSR, at least for a short time. They can
create a higher TSR by delivering performance that raises shareholder expectations to the level of expectations for their peers in
the sector.
Good company ¹ good investment, in the short term, because future great performance might already be built into the share
price. Smart investors may prefer weaker-performing companies, because they have more upside potential, as the expectations
expressed in their lower share prices are easier to beat = contrarian investing
5.2 The treadmill’s real-world effects
J&J Snack Foods outperformed in growth and ROIC, but earned substantially lower TSR, because its market expectations
(EV/NOPAT) were higher 23x vs. Tyson’s 13x.
This means that J&J’s treadmill was already running fast, with high expectations already built into the share price. Therefore, if
you already pay for high expectations you will most likely not earn high returns.
5.3 Decomposing TSR
Decompose TSR:
1. Understand the sources of TSR which allows better evaluation of management
2. Helps with future targets of TSR
For high-performing companies, TSR in isolation can unfairly penalize their high performance. Another drawback is that using
TSR by itself, without understanding its components, doesn’t help executives or their boards understand how much of the TSR
comes from operating performance, nonoperating items, and changes in expectations.
4
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