3. 3
Contents
• Part1 Foundations of Value
• Part2 Core Valuation Techniques
• Part3 Intrinsic Value and the Stock Market
• Part4 Managing for Value
• Part5 Advanced Valuations Issues
• Part6 Special Situations
5. 5
Contents
• Part1 Foundations of Value
• Part2 Core Valuation Techniques
• Part3 Intrinsic Value and the Stock Market
• Part4 Managing for Value
• Part5 Advanced Valuations Issues
• Part6 Special Situations
6. What
is
value
In
the
context
of
valua3on
and
in
your
life
?
6
7. What is Value?
• Value is defining dimension of measurement in a market
economy.
• Value is a particularly helpful measure of performance because
it takes into account the long-term interests of all the
stakeholders in a company,not just shareholders.
• Competition among value-focused companies also helps to
ensure that capital,human capital,and natural resources are
used efficiency across the economy,leading to higher living
standards for everyone.
7
(P3)
8. Fundamental principles of corporate finance
Companies create value by investing capital to
generate future cash flow at rate of return that
exceed their cost of capital. (P17)
8
9. Two core principles of value creation
• 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.
• Conservation of value
– Anything that doesn't increase cash flow doesn't create
value.
– M・M
theory
9
(P4)
10. 10
Growth and ROIC:Drives of Value
Return on
investment capital
Revenue growth
Cash flow
Cost of of Capital
Value
11. 11
Contents
• Part1 Foundations of Value
• Part2 Core Valuation Techniques
• Part3 Intrinsic Value and the Stock Market
• Part4 Managing for Value
• Part5 Advanced Valuations Issues
• Part6 Special Situations
12. 12
Part2 Core Valuation Techniques
6. Framework for Valuation
7. Reorganizing the Financial Statements
8. Analysand Performance and Competitive Position
9. Forecasting Performance
10. Estimating Continuing Value
11. Estimating the Cost of Capital
12. Moving from Enterprise Value to per Share
13. Calculating and Interpreting Results
14. Using Multiple
13. 13
Framework for DCF-Based Valuation
EXHIBIT 6.1
Model Measure Discount factor Assessment
Enterprise discounted
cash flow
Free cash flow
Weighted average
cost of capital
Works best for projects, business units, and
companies that manage their capital
structure to a target level.
Discounted economic
profit
Economic profit
Weighted average
cost of capital
Explicity highlights when a company creates
value.
Adjusted present value Free cash flow
Unlevered cost of
equity
Highlights changing capital structure more
easily than WACC-based models.
Capital cash flow Capital cash flow
Unlevered cost of
equity
Compresses free cash flow correctly
because capital structure is embedded
within the cash flow.Best used when valuing
financial institutions.
Equity cash flow
Cash flow to
equity
Levered cost of
equity
Difficult to implement correctly because
capital structure is embedded within the
cash flow. Best used when valuing financial
institutions.
(P104)
14. 14
Home Depot:
Enterprise DCF
Forcaset year
Free cash flow
($ million)
Discount factor
(@ 8.5%)
Present value of
FCF
(& million)
2009 5,909 0.922 5,448
2010 2,368 0.850 2,013
2011 1,921 0.784 1,506
2012 2,261 0.723 1,634
2013 2,854 0.666 1,902
2014 3,074 0.614 1,889
2015 3,308 0.567 1,874
2016 3,544 0.522 1,852
2017 3,783 0.482 1,822
2018 4,022 0.444 1,787
Continuing value 92,239 0.444 40,966
Present value of cash flow 62,694
Midyear adjustment factor 1.041
Value of operations 65,291
Value of excess cash -
Value of long-term investments 361
Value of tax loss carry-forwards 112
Enterprise value 65,764
Less:Value of debt (11,434)
Less:Value of capitalized operating leases (8,298)
Equity value 46,032
Number of shares outstanding(December 2008) 1.7
Equity value per share 27.1
Forecasting performance
Estimating Continuing Value
15. 15
Enterprise valuation of
a multibusiness company
Unit A Unit B Unit C Corporate
center
Value of
operations
Nonoperating
assets
Enterprise
Value
Value
of debt
Equity
Value
Exhibit6.3 P106
Value of operating units
200
30
560
125
200
225
520
40
360
16. 16
Contents
• Part1 Foundations of Value
• Part2 Core Valuation Techniques
• Part3 Intrinsic Value and the Stock Market
• Part4 Managing for Value
• Part5 Advanced Valuations Issues
• Part6 Special Situations
17. Part3 Intrinsic Value and the Stock Market
15 Market value tracks return on invested capital and growth
16 Markets value substance, not form
17 Emotions and mispricing in the markets
18 Investors and managers in efficient markets
17
18. Research Findings
• Valuation levels for the stock market as a whole clearly reflect the
underlying fundamental performance of companies in the real
economy.
• Companies with higher ROIC and those with higher growth are
valued more highly in the stock market.
• Over the long term(10 years and more), higher ROIC and growth
also lead to higher total returns to shareholders(TSR) in the stock
market.
• Whether increasing revenue growth or return on capital will create
more value depends on the company’s performance.
18
19. Markets value substance, not form
• Managers can go to great lengths to achieve analysts’ expectations
of EPS or to smooth earnings from quarter to quarter.
• Stock markets are perfectly capable of seeing the economic reality
behind different forms of accounting information.
• Since investors value substance over form, managers need not
worry about whether their share are spilt into smaller shares, traded
in one or many developed stock markets, or included in a large
stock market index.
19
20. Patterns in mispricing
• Individual company share price deviate significantly from
the company’s fundamentals value only in rare
circumstances.
• Market wide price deviations from fundamental
valuations are even less frequent, although they may
appear to be becoming more so.
• Price deviation from fundamentals are
temporary(typically three years).
20
21. The implication of market efficiency
for managers
• Managers should focus on driving return on ROIC and
growth to create maximum value for shareholders.
• Managers need to understand their investor base, so
they can communicate their company’s strategy for value
creation effectively to different investor segments.
• Managers should not be distracted from their efforts to
drive ROIC and growth by any short-term price volatility.
21
22. 22
Contents
• Part1 Foundations of Value
• Part2 Core Valuation Techniques
• Part3 Intrinsic Value and the Stock Market
• Part4 Managing for Value
• Part5 Advanced Valuations Issues
• Part6 Special Situations
23. Part4 Managing for Value
• Chap19 Corporate Portfolio Strategy
• Chap20 Performance Management
• Chap21 Mergers and Acquisitions
• Chap22 Creating Value through Divestitures
• Chap23 Capital Structure
• Cahp24 Investor Communications
23
24. Constructing the portfolio
1. Determine the company’s current market value, and compare it with the
company’s value as is.
2. Identify and value opportunities to improve operations internally.
– By increasing margins, accelerating core revenue growth, and improving capital efficiency.
3. Evaluate whether some business should be divested.
4. Identify potential acquisitions or other initiatives to create new growth, and
improving on value.
5. Estimate how the company’s value might be increased through changes in
its capital structure or other financial strategy changes.
24
27. Short term value drivers
• Short-term value drivers are the immediate drivers of historical ROIC
and growth.
27
Sales productivity
Operating cost
productivity
The drivers of recent sales growth, such as price and
quantity sold, market share, the company’s ability to
charge higher prices relative to peers, sales force
productivity
Capital
productivity
The drivers of unit costs, such as the component
costs for building an automobile or delivering a
package.
How well a company uses its working
capital(inventories, receivables, and payables) and
its property, plant , and equipment
28. Medium-term value drivers
• Medium-term value drivers look forward to indicate whether a
company can maintain and improve its growth and ROIC.
28
Commercial
health
Cost structure
health
Whether the company can sustain or improve its
current revenue growth.
The company’s product pipeline, brand strength,
customer satisfaction
Asset health
Company’s ability to manage its costs relative to
competitors over three to five years.
How well a company maintains and develops its
assets.
29. Long term strategic value drivers
and Organizational health
• Long term strategic value drivers
– The ability of an enterprise to sustain its current operating
activities and to identify and exploit new growth areas.
• Organizational health
– Whether the company has the people, skills, and culture to
sustain and improvement
29
30. Value creation framework
• Acquisitions create value when the cash flows of combined
companies are greater than they would have otherwise been.
30
Value Created for Acquirer= Value received – Priced Paid
Value Created for Acquirer= (Standard Alone value of target)
＋Value of performance improvements)
−(Market Value of target＋Acquisition premium)
31. Deciding on transaction type
31
Forms of
divestiture
Private
transaction
Private
transaction
Public
transaction
Joint venture
Tracking stock
Spilt off
IPO
Carve out
Spin off
(or demerger)
Sales of part or all of a business to a strategic or
financial investor
A combination of part or all of a business with
other industry players, other companies in the
value chain, or venture capitalists
A separate class of parent shares that is distributed to
exiting shareholders of the parent company through a spin-
off or sold to new shareholders through a carve out
An offer to existing shareholders of the company
to exchange their shares of the parent company
for shares in the subsidiary
Sale of all shares of a subsidiary to new share
holders in the stock market
Sale of part of the shares in a subsidiary to new
shareholders in the stock market
Distribution of all shares in a subsidiary to existing
shareholders of the parent company
32. Investor communications
• The overriding objective of investor communications must be to align
a company’s share price with management’s perspective on the
intrinsic value of the company.
• While there are no formulas for achieving good investor
communications, we find that companies can improve in several
areas.
– Companies need to know whether there is a material discrepancy between their
intrinsic value and their market value that their investor communications should
aim to close.
– For companies to understand their investor base.
– Many companies don’t tailor their communications to the investors who matter
most to their share price.
32
33. Part5 Advanced Valuation Issues
• 25 Taxes
• 26 Nonoperating Expenses,One-time Charges, Reserves, and Provisions.
• 27 Leases, Pensions, and Other Obligations
• 28 Capitalized Expenses
• 29 Inflation
• 30 Foreign Currency
• 31 Case Study: Heineken
33
34. 25 Taxes
1. Operating taxes on the reorganized income statement
2. Converting operating taxes to operating cash taxes
3. Deferred taxes on the reorganized balance sheet
4. Valuing deferred taxes
34
35. Taxes
• In this chapter, we go through the steps of estimating
operating taxes, converting taxes to operating cash
taxes, and incorporating deferred taxes into a corporate
valuation.
35
36. 1 Operating taxes
on the reorganized income statement
• To determine operating taxes, we need to remove the effects of
nonoperating and financing items from reported taxes.
• Operating taxes are computed as if the company were financed
entirely with equity.
36
P544 exhibit25.1
37. Why EV to EBITA,
not EV to EBIT
37
P318 exhibit14.4
• Amortization is an accounting artifact that arises from
past acquisitions.
• It is not tied to future cash flows, amortization will distort
an enterprise value multiple.
38. Why EV to EBITA,
not EV to EBITDA
• Many practitioners use EBITDA multiples because depreciation is, strictly speaking, a noncash
expense, reflecting sunk costs, not future investment.
– This logic does not apply uniformly.
• For many industries, depreciation of existing assets is the accounting equivalent of setting aside
the future capital expenditure that will be required to replace the assets.
• In certain situations, EBITDA scales a company’s valuation better than EBITA.
– These occurs when current depreciation is not an accurate predictor of future capital
expenditures.
38
P320 exhibit14.5
39. Various type of cash flow in Finance
39
Corporate
Finance
Real Estate
Finance
EBIT
Earnings before interest, taxes
NCF
Net Cash Flow
Project
Finance
CFADS
Cash flow available for debt
service
40. Computing operating taxes
using public statement
• In practice, companies do not give a full breakout of the income statement
by geography, but provide only the corporate income statement and a tax
reconciliation.
• The most comprehensive method for computing operating taxes from public
data is to begin with reported taxes and undo financing and nonoperating
items one by one.
40
P546 Exhibit25.3
41. Computing operating taxes:
Simple methods to contend with incomplete date
• If marginal tax rates on nonoperating items are not reported, you will
have to make an assumption about the tax jurisdiction in which
nonoperating items are held.
• If you believe the company records interest expenses and other
nonoperating items domestically, multiply the statutory tax rate by
EBITA , and then adjust for other operating taxes.
• If you believe the company reports interest expense and other
nonoperating items in various geographies proportional to each
geography’s profits, multiply a blended global rate by EBITA, and
adjust for other operating taxes.
41
43. 2 Converting operating taxes
to operating cash taxes
• In the previous section, we estimated accrual based
operating taxes as if the company were all equity
financed.
• A cash tax rate represents value better than accrual-
based taxes.
• To convert operating taxes to operating cash taxes,
subtract the increase in net operating deferred tax
liabilities from operating taxes.
43
44. Operating DTAS and DTLs
• Warranty reserves(a DTA):
– The company records an expense for promised warranties when
it sells the product. The government recognizes a deductible
expense only when a product is repaired, so cash taxes typically
understate the actual cash taxes paid.
• Accelerated depreciation(a DTL):
– The company uses straight line depreciation for its GAAP/IFRS
reported statements and accelerated depreciation for its tax
statements(because larger depreciation expenses lead to
smaller taxes.)
44
45. Nonoperating DTAs and DTLs
• Tax loss carry-forwards(a DTA)
– Since tax loss carry-forwards are valuable, they must be valued
separately.
• Pension and postretirement benefits(a DTA)
– Deferred taxes arise when reported pension expense differs from cash
contributions.
• Nondeductible intangibles(a DTL)
– Since operating taxes exclude the amortization tax shield from the
investor’s statement, no adjustment for deferrals related to such
intangible assets should be made to operating taxes. Instead, treat
deferred taxes related to amortization of intangibles as nonoperating.
45
46. Deferred tax asset and
liability reorganization
• Exhibit 25.7 reorganizes the items in the note about deferred tax
assets and liabilities into operating and nonoperating items.
• To convert accrual-based operating taxes into operating cash taxes,
subtract the increase in net operating DTLs(net of DTAs) from
operating taxes.
46
P552 exhibit25.7
$million
Current year
Operating taxes
760
Dcrease(increase) in net operating DTLs
-150
Opearating cash taxes
610
47. 3 Deferred taxes
on the reorganized balance sheet
• Exhibit25.8 presents a reorganized balance sheet that includes the
five deferred tax items from Exhibit 25.7.
47
48. 4 Valuing deferred taxes
1. Value as part of NOPLAT and subsequently enterprise value
2. Value as part of a corresponding nonoperating asset or liability.
3. Value as a separate nonoperating asset.
4. Ignore as an accounting convention.
48
49. Part5 Advanced Valuation Issues
• 25 Taxes
• 26 Nonoperating Expenses,One-time Charges, Reserves, and Provisions.
• 27 Leases, Pensions, and Other Obligations
• 28 Capitalized Expenses
• 29 Inflation
• 30 Foreign Currency
• 31 Case Study: Heineken
49
50. 26 Nonoperating Expenses, One-time
Charges, Reserves, and Provisions.
1. Nonoperating Expenses and One-time charges
2. Reserves, and Provisions
50
51. 26 Nonoperating Expenses, One-time
Charges, Reserves, and Provisions.
• The conventional wisdom is to ignore nonoperating
expenses in DCF calculations as backward-looking, one
time costs.
• Research shows that the type and accounting treatment
of nonoperating expenses can affect future cash flow
and must be incorporated into operating cash flow.
• Adjustment for nonoperating expenses will also make
assessments of past performance more accurate.
51
52. Nonoperating expenses
and one-time charges
1. Reorganize the income statement into operating and
nonoperating items.
2. Search the notes for embedded one-time items.
3. Analyze each extraordinary item for its impact on future
operations.
52
53. 1. Reorganizing the income statement
• For us to benchmark core operations effectively, EBITA and net operating
profit less adjusted taxes(NOPLAT) should include only items related to the
ongoing core business, regardless of their classification by accounting
standards.
• Note how the account’s definition of operating income fluctuates wildly is
relatively stable.
53
Exhibit26.1
54. Analyzing each extraordinary item
for impact on future operations
• A highly profitable company that reports a series of ,say,
restructuring charges is likely to continue with similar
charges in the future.
• A comprehensive list of nonoperating items and one-time
charges is impractical, but the following items are the
most common:
– Amortization expense, asset write-offs including write-offs of
good will and purchased R&D, restructuring charges, litigation
charges, and gains and losses on asset sales.
54
55. 2.Provisions and their corresponding reserve
• Provisions are noncash expenses that reflect future
costs or expected losses.
• For the purpose of analyzing and valuing a company, we
categorize provisions into one of four types.
– Ongoing operating provisions
– Long term operating provisions
– Nonoperating provisions
– Income smoothing provisions
55
57. Adjustment for the provisions
• In exhibit26.5, we present the abbreviated financial statements for a
hypothetical company that recognize four types of provisions.
– A provision for future product returns
– An environmental provision for decommissioning the company’s plant in four
years
– A provision for smoothing income
– A restructuring provision for future severance payments
57
P569 exhibit26.5
58. List of nonoperating items
58
Long term operating
provisions
One-time restructuring
provisions
When a company decommissions a plant, it must pay
for cleanup and other costs.
When management decides to restructure a company, it will
often recognize certain future expenses immediately. We
recommend treating one-time provisions as nonoperating and
treating the corresponding reserve as debt equivalent.
Income smoothing
provisions
In some countries, provisions can be manipulated to
smooth earnings.
Provisions and taxes
In most situations, provisions are tax deductible only
when cash is dispersed, not when the provision is
reported.
Provisions
related to ongoing
operations
When a company warranties a product, expects that some
products will be returned , or self-insurance service, it must
create a corresponding liability when that product or service is
sold.
59. Part5 Advanced Valuation Issues
• 25 Taxes
• 26 Nonoperating Expenses,One-time Charges, Reserves, and Provisions.
• 27 Leases, Pensions, and Other Obligations
• 28 Capitalized Expenses
• 29 Inflation
• 30 Foreign Currency
• 31 Case Study: Heineken
59
60. Leases, Pensions, and Other Obligations
• When a company borrows money to purchase an asset, the asset is
listed on the company’s balance sheet matched by a corresponding
obligation. However, clever use of existing accounting rules has
allowed companies to keep many assets and their corresponding
debts “off balance sheet”.
• The two most common forms of off-balance sheet debt are operating
lease and securitized receivables. Another well-known type of off
balance sheet item is unfunded pension liabilities.
• We show how to recapitalized each item on the balance sheet,
compute the new ROIC , and compare the result with the raw
calculations.
60
61. Operating Lease
• The process for adjusting financial statements and
valuation for operating leases consists of three steps.
1. Reorganize the financial statements to reflect operating leases
appropriately
2. Build a WACC that reflects adjusted debt-to-enterprise value.
3. Value the enterprise by DCF at the adjusted cost of capital.
61
62. Leasing Example:
Financial statement
• The value of capitalized operating lease is added to book assets to
long term debt.
• Implicit lease interest expense is removed from operating profit. To
compute the implicit interest expense, multiply the value of operating
leases by the cost of secured debt, which we assume 5%.
62
P578 Exhibit27.1
66. Value the enterprise
• Since valuation is not affected by the treatment of operating leases,
you may wonder why is worth the effort to adjust the financial
statement. The answer is that capitalizing operating lease is a
critical step in competitive benchmarking.
66
P582 exhibit27.6
67. Estimating the value of leased assets
• Many in the investment banking community multiply rental expenses
by 8times to approximate asset value.
67
68. Securitized receivables
• By selling a portion of its receivables, the company will reduce
receivables on the balance sheet and increase cash flow from
operations on the accountant’s cash flow statement.
• In reality, the company pays a fee for the arrangement, reduces its
borrowing capacity, and pays higher interest rates on unsecured
debt.
• Interest rates are low because the collateral is short-term and
generally recoverable compared with the company’s traditional
unsecured debt.
68
69. Pensions and other
postretirement benefit
• Identify excess pension assets and unfunded liabilities on the
balance sheet.
• Add excess pension assets to and deduct unfunded pension
liabilities from enterprise value.
• To reflect accurately, the economic expenses of pension benefits
given to employees, remove the accounting pension expense from
cost of sales, and replace it with the service cost and amortization of
prior service costs reported in the notes.
69
70. Analyzing and valuing pensions
DuPont example
• Under the new U.S standards, the balance sheet must
match the actual funding status in every period.
70
P588 exhibit27.7
71. Value excess pension assets and
unfunded pension liabilities
• To incorporate pensions for a company with net excess
assets, add(1-marginal tax rate)×net pension assets to
enterprise value, as excess pension assets will lead to
fewer required contributions in the future.
• To value companies with net unfunded liabilities, deduct
(1- marginal tax rate)× net pension liabilities from
enterprise value.
71
72. Adjust the income statement for pensions
• The remaining items- interest cost, expected return on plan assets,
and amortization of loss- are related to the performance of the plan
assets, not the operation of business.
72
P589 exhibit27.8
