Samenvatting
Summary Corporate Valuation
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This is a detailed summary plus formula sheet of Corporate Valuations for Finance
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Final summary Corporate ValuationsLecture 1 – Principles of Value Creation
DCF valuations
- Are used a lot in practise
- But why?
▪ Because it gives you an insight into what is the fundamental value of any
asset
▪ So, even if the market completely overvalues/ undervalues all assets, it
should not matter for your DCF valuation
- To use discounted cash flow valuation, you need
▪ To estimate the life of the asset
▪ To estimate the cash flow during the life of the asset
▪ To estimate the discount rate to apply to these cash flows to get the present
value
- It works best for investors who either:
▪ Have a long-time horizon, allowing the market time to correct is valuation
mistakes and for price to revert to “true” value or
▪ Are capable of providing the catalyst needed to move price to value, as would
be the case if you were an activist investor or a potential acquirer of the
whole firm
Does DCF analysis work best for investors who have a long-time horizon?
- Yes, because market can over- or undervalue assets, but sooner or later the value of
assets should somewhat converge back to fundamentals
- However, this may take a long time
- So, that even if assets are undervalued, it may take a long time before they are back
at their fundamental value
Advantages of DCF valuation
- Since DCF valuation, done right, is based upon an asset’s fundamentals, it should be
less exposed to market moods and perceptions
- If good investors buy businesses, rather than stocks (the Warren Buffet adage),
discounted cash flow valuation is the right way to think about what you are getting
when you buy an asset
- DCF valuation forces you to think about the underlying characteristics of the firm,
and understand its business
▪ If nothing else, it brings you face to face with the assumptions you are making
when you pay a given price for an asset
Disadvantages of DCF valuation
- Requires far more inputs and information than other valuation approaches
- Inputs are noisy and can be manipulated
- No guarantee that anything will emerge as under or overvalued
▪ This can be a problem for:
, o Equity research analyst, whose job it is to follow sectors and make
recommendations on the most under and overvalued stocks in that
sector
o Equity portfolio managers, who have to be fully (or close to fully)
invested in equities
Basic principle – parsimony
- When valuing an asset, we want to use the simplest model we can get away with
- Don’t go looking for trouble and estimate inputs that you do not have
- You can manage simple assets using complicated valuation models
- All-in-one valuation models that try to value all companies, by definition, will be far
more complicated than they need to be, since they have to be built for the most
complex company that you will run into
As long as ROIC > COC you are creating value
- Returns > costs, means you are making a profit
If ROIC > COC growth will create value
- Because you are creating value with your activities
- So, the greater the activities, the more these activities grow, the more value you are
creating
If ROIC < COC, you are destroying value
- Because the bigger you grow the more value you are destroying
If you are a high-ROIC company
- Generating more growth will typically be better for creating more value (than
increasing ROIC)
If you are a low/moderate-ROIC company
- It is typically better to focus on increasing ROIC (than increasing growth)
The higher my ROIC the cheaper it will be for me to generate growth by reinvestment/ the
less I need to invest to generate some amount of growth
- If I have higher ROIC, I only have to invest very little to generate a lot of return
Relationship growth and ROIC
- Growth and ROIC are related
▪ After all, if a company makes a high return, it should be able to convert
investment into growth:
o 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑔𝑟𝑜𝑤𝑡ℎ 𝑖𝑛 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒 = 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 ∗
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
o 𝑔 = 𝐼𝑅 ∗ 𝑅𝑂𝐼𝐶
▪ This also implies that growth is not free, if you expect a company to grow a lot
this company should either have a high ROIC or invest a lot of its earnings
back to growth
▪ Another way to write this formula is:
, 𝑔
o 𝐼𝑅 = 𝑅𝑂𝐼𝐶
The growing perpetuity formula
- A company is worth the present value of its future free cash flows
▪ If free cash flows grow forever at a constant rate:
o We can use the growing perpetuity formula to value a company
𝐹𝐶𝐹1 𝐹𝐶𝐹2 𝐹𝐶𝐹3
▪ 𝑉𝑎𝑙𝑢𝑒 = (1+𝑊𝐴𝐶𝐶) + (1+𝑊𝐴𝐶𝐶)2 + (1+𝑊𝐴𝐶𝐶)3 + ⋯
Via the growing
𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘𝟏
▪ 𝑽𝒂𝒍𝒖𝒆 = perpetuity formula
𝑾𝑨𝑪𝑪−𝒈
What drives value
𝐹𝐶𝐹1
- 𝑉𝑎𝑙𝑢𝑒 = 𝑊𝐴𝐶𝐶−𝑔
▪ As cash flow rises, what happens to value?
▪ As weighted average cost of capital (WACC) rises, what happens to value?
▪ As growth rises, what happens to value?
Deriving the key value driver formula
- In order to develop the key value driver formula, we will rely on a couple of
substitutions
𝒈
𝑭𝑪𝑭𝟏 𝑁𝑂𝑃𝐴𝑇1 (1−𝐼𝑅) 𝑵𝑶𝑷𝑨𝑻𝟏 (𝟏 − )
▪ 𝑽𝒂𝒍𝒖𝒆 = = = 𝑹𝑶𝑰𝑪
𝑾𝑨𝑪𝑪−𝒈 𝑊𝐴𝐶𝐶 − 𝑔 𝑾𝑨𝑪𝑪 − 𝒈
▪ 𝑭𝑪𝑭 = 𝑵𝑶𝑷𝑨𝑻(𝟏 − 𝑰𝑹) = 𝐸𝐵𝐼𝑇(1 − 𝜏)(1 − 𝐼𝑅)
𝒈
▪ 𝑰𝑹 = 𝑹𝑶𝑰𝑪
𝑷𝒓𝒊𝒄𝒆−𝑪𝒐𝒔𝒕𝒔
▪ 𝑹𝑶𝑰𝑪 = (𝟏 − 𝝉) ∗ 𝑰𝒏𝒗𝒆𝒔𝒕𝒆𝒅 𝑪𝒂𝒑𝒊𝒕𝒂𝒍
- Terminology used by consulting firms
▪ Profit: after-tax operating profit (NOPAT)
▪ ROIC: return on invested capital (ROI)
▪ WACC: weighted average cost of capital (hurdle rate)
▪ g: long-term growth in profit and cash flows
what drives value
𝒈
𝑵𝑶𝑷𝑨𝑻𝟏 (𝟏 − 𝑹𝑶𝑰𝑪)
- 𝑽𝒂𝒍𝒖𝒆 = 𝑾𝑨𝑪𝑪 − 𝒈
𝑁𝑂𝑃𝐴𝑇1 (𝑅𝑂𝐼𝐶 − 𝑔)
- 𝑉𝑎𝑙𝑢𝑒 = 𝑅𝑂𝐼𝐶 𝑊𝐴𝐶𝐶 − 𝑔
𝟏 𝑵𝑶𝑷𝑨𝑻
- 𝑺𝒊𝒏𝒄𝒆: 𝑹𝑶𝑰𝑪 = 𝑰𝒏𝒗𝒆𝒔𝒕𝒆𝒅 𝑪𝒂𝒑𝒊𝒕𝒂𝒍
𝟎
(𝑹𝑶𝑰𝑪 − 𝒈)
- 𝑽𝒂𝒍𝒖𝒆 = 𝑰𝒏𝒗𝒆𝒔𝒕𝒆𝒅 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 (𝑾𝑨𝑪𝑪 − 𝒈)
▪ As ROIC rises, what happens to value?
𝜕𝑉𝑎𝑙𝑢𝑒 1
o = 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 >0
𝜕𝑅𝑂𝐼𝐶 𝑊𝐴𝐶𝐶 − 𝑔
▪ As WACC rises, what happens to value?
, 𝜕𝑉𝑎𝑙𝑢𝑒 𝑅𝑂𝐼𝐶 − 𝑔
o = −𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 <0
𝜕𝑊𝐴𝐶𝐶 (𝑊𝐴𝐶𝐶 − 𝑔)2
▪ As growth rises, what happens to value?
𝜕𝑉𝑎𝑙𝑢𝑒 −𝑊𝐴𝐶𝐶 + 𝑔 − (−𝑅𝑂𝐼𝐶 + 𝑔)
o = 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝜕𝑔 (𝑊𝐴𝐶𝐶 − 𝑔)2
𝑅𝑂𝐼𝐶 − 𝑊𝐴𝐶𝐶
o = 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 (𝑊𝐴𝐶𝐶 − 𝑔)2
𝜕𝑉𝑎𝑙𝑢𝑒
o > 0, 𝑤ℎ𝑒𝑛 𝑅𝑂𝐼𝐶 > 𝑊𝐴𝐶𝐶
𝜕𝑔
𝜕𝑉𝑎𝑙𝑢𝑒
o < 0, 𝑤ℎ𝑒𝑛 𝑅𝑂𝐼𝐶 < 𝑊𝐴𝐶𝐶
𝜕𝑔
Long-run ROIC = sustainable competitive advantage
- The efficient use of capital will improve short-term ROICs, but to maintain long-term
ROICs above the cost of capital, the company also needs a sustainable competitive
advantage
- Key:
▪ Difficult to copy
- For instance, pharmaceutical companies tend to have high ROICs (ranging between
20-30% between 1998 and 2008) because cost of production is low (scale) and
barriers to entry (R&D and patent protection) are high
A deeper look at ROIC
- Return on invested capital equals the company’s after-tax operating profit divided by
the amount of operating capital the company requires to run operations:
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒑𝒓𝒐𝒇𝒊𝒕
▪ 𝑹𝑶𝑰𝑪 = (𝟏 − 𝝉) 𝑰𝒏𝒗𝒆𝒔𝒕𝒆𝒅 𝒄𝒂𝒑𝒊𝒕𝒂𝒍
- Divide both sides by the number of units the company produces:
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒑𝒓𝒐𝒇𝒊𝒕 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕
▪ 𝑹𝑶𝑰𝑪 = (𝟏 − 𝝉) 𝑰𝒏𝒗𝒆𝒔𝒕𝒆𝒅 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕
- Finally, separate operating profit into price minus costs a superior ROIC results from
either a price premium relative to peers or a lower invested capital per unit (or
both):
𝑷𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕 − 𝑪𝒐𝒔𝒕 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕
▪ 𝑹𝑶𝑰𝑪 = (𝟏 − 𝝉) 𝑰𝒏𝒗𝒆𝒔𝒕𝒆𝒅 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕
Sources of competitive advantage
- As shown, a superior ROIC results from either a price premium relative to peers, a
better cost structure or less capital required per unit (or both):
- Example:
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