Chapter 2 on Valuation and Reporting in Organization

Chapter 2: Fundamental
Principles of Value Creation

Outline
1.FIVE LESSONS OF VALUE CREATION
2.FRED’S HARDWARE
2.1 Small chain of hardware stores
2.2 Idea of Fred’s Superhardware
2.3 Economic Profit vs DCF
2.4 Going Public
2.5 Expanding to new concepts
3.Discounted Cash Flow Approach
4.Drivers of Cash Flow and Value
5.The Zen of Corporate Finance
6.DCF and Present Value of Economic Profit
7.ROIC And Growth Drive Multiples
8.Multiples
9.Summary
Chapter 2. Fundamental Principles of Value Creation
2

1. FIVE LESSONS OF VALUE
CREATION
 In the real market, you create value by earning a return on your
invested capital greater than the opportunity cost of capital
 The more you can invest at returns above the cost of capital, the
more value you create.
 You should select strategies that maximize the present value of
expected cash flows or economic profit.
 The value of a company’s shares in the stock market is based on the
market’s expectations of future performance.
 After an initial price set, the returns that shareholders earn depend
more on the changes in expectations about the company’s future
performance than actual performance of the company.
3

2. FRED’S HARDWARE VALUE
CREATION
4

 Starting with the measuring return on invested capital (ROIC)
and compare it with what could be earned if invested the capital
elsewhere (stock market)
The objective is to maximize Economic Profit over the
long term not ROIC.
5

As shown in the exhibit, if he develops this new
business his economic profit would decline in the next
few years because of the new capital required.
After four years, economic profit would be greater, but
he did not know how to trade off the short-term
decline in economic profit against the long-term
improvement.
At this stage, using the straight forward economic
profit framework would not offer a clear answer.
One method is to use discounted cash flow or DCF.
6

 The Discounted Cash Flow (DCF)
value of Fred’s company without
new concept was $53 million while
with the new concept the
Discounted Cash Flow (DCF)
value increased to $62 million. The
value was discounted at 10%.
7

What is a 'Discounted Cash Flow (DCF)
valuation method?
 Discounted cash flow (DCF) is a valuation method used to estimate the
attractiveness of an investment opportunity. DCF analyses use future free
cash flow projections and discounts them, using a required annual rate,
to arrive at present value estimates.
 A present value estimate is then used to evaluate the potential for
investment.
 If the value arrived at through DCF analysis is higher than the current
cost of the investment, the opportunity may be a good one.
8

 If we discount all of the projected
economic profit at the same cost of
capital, and add the discounted economic
profit to the amount of capital invested
today, there would be the same result as
in the DCF approach.
9

 When a company goes public, it will sell its shares to a wide range
of investors who can trade those shares in an organized market.
 As a public listed company, the return that investors earn is driven
not by the performance of the company but by the performance
relative to expectations.
 Company needs to manage its performance in the real markets
and the financial markets at the same time.
 Manager’s task is to maximize intrinsic value of the company
and to properly manage the expectations of the financial
market.
10

Company needs
 planning and control system that tells about the “health” of
the company, the ability of the company to continue growing
and creating value.
 system that incorporates forward-looking metrics not just
backward-looking ones.
11

The DCF model accounts for the difference in value by
factoring in the capital spending and other cash flows required
to generate earnings.
Free Cash Flow perpetuity formula is:
which assumes that a company’s cash flow will grow at a
constant rate forever.
12

1.The rate at which the company can grow its revenues and
profits
2.Return on invested capital (relative to the cost of capital).
A company that earns higher profits per dollar invested will
be worth more than a company that cannot generate the
same level of returns. Similarly, a faster growing company
will be worth more than a slower growing company if they
both earn the same return on invested capital
13

14

 The key value driver is called the Zen of
Corporate Finance because it relates a
company’s value to the fundamental
drivers of economic value: growth,
ROIC, and the cost of capital.
 The formula is used in practice rarely,
because it assumes a constant ROIC
and growth rate going forward. So this
model is not flexible and cannot be used
for most of the companies.
15
where: NOPLAT- Net Operating Profit Less Adjusted Tax
g- projected growth in NOPLAT (g=ROIC*IR)

 Advantage of the economic profit model over the DCF model
is that economic profit is a useful measure for understanding
a company’s performance in any single year, whereas free
cash flow is not.
Economic Profit translates size, return on capital, and cost of
capital into a single measure.
16
Economic Profit =Invested Capital x (ROIC – WACC)

17
Value = Invested Capital + Present Value of Projected Economic Profit
Note: If the company earned exactly its WACC every period, then
the discounted value of its projected free cash flow should exactly
equal its invested capital.
Where:

 Company’s earnings multiple is driven by both its expected growth
and its return on capital.
 Multiples are driven by both growth and ROIC.
18

 Earnings multiples are a useful shorthand of communications
and a useful sanity check for company’s valuation
 Used at comparing a company’s implied multiple with its
peers to see if it can be explained why its multiple is higher
or lower (due to growth or ROIC).
“Company X deserves a higher multiple than Company Y,
because it is expected to grow faster, earn higher margins,
or generate more cash flow”
19

 In this chapter we learned that value is driven by expected
cash flows.
 Cash flow, in turn, is driven by expected returns on capital
and growth.
20

Questions?
21

Table of Content
 1.0 Financial Objectives of the Firm
 2.0 Managers’Value Creation Strategies
 3.0 How Companies Create Value?
 4.0 Economic Fundamentals
 5.0 Stock Market Long-term Returns
 5.1 Cross Country Comparisons
 6.0 Sloppy Economic Analysis
 7.0 Market Bubbles
 7.1 LBO Bubble
 7.2 The Internet Bubble
 8.0 Value Leads To Healthier Companies
 9.0 Short-term Earnings vs. Long-term Value Creation
Valuation and Reporting in Organizations

What are The Financial Objectives Of a Firm
 The stakeholders financial objectives of
the firm are:
 Profit Maximization
 Wealth Maximization
 The stakeholders financial objectives of
the firm are:
 Growth
 Diversification
 Survival
 Maintaining contended workforce
 Becoming research and development leader
 Providing top quality service to customers
 Maintaining respect for the environment

Managers’ Value Creation Strategies
Manager should focus on the financial objective of the
shareholder, creating shareholder value
Managers who focus on shareholder value, create
healthier companies, which in turn provide spillover
benefits: stronger economies, higher living standards,
and more employment opportunities.
Companies thrive when they create real economic value
for their shareholders.

Managers’ Value Creation Strategies
(cont’d)
What managers need to do? Managers need to:
 Have theoretical understanding of value creation
 Set tangible links between their strategies and value creation
 Install performance management systems that encourage real
value creation, not merely short-term accounting results.
 Educate their investors about how and when the company will
create value

How Companies Create Value?
Companies create values by investing capital at rates of
return that exceed their cost of capital
Greater value are created by having growth of returns
on capital exceeding cost of that capital, will create more
value to the company
Value creation principles must be part of important company
decisions such as corporate strategy, mergers, acquisitions,
capital structure.

Economic Fundamentals
 U.S stock market’s behavior from 1980 through today is
confusing.
The performance is explained by how closely the stock
market has mirrored economic fundamentals throughout a
century of technological revolutions, monetary changes,
political and economic crisis and wars
The situation is true for European and Asian stock markets,
considering regional different economic prospects.

5. Shareholder Return Index
US equity return on common
stock was on average 6.5% over
the past 200 years, adjusted for
inflation.
Adding the annual 3 to 3.5%
increase in share prices to the
cash yield of 3 to 3.5 % results
in total real shareholder returns
of about 6.5% per year.

5.1 Market Price Levels and
Fundamentals

Stock Market Long-term Returns
Elements that were responsible for nearly all the change in
the broad market index are:
Growth in earning
Declines in interest rates and inflation
Temporary emergence of so called mega capitalization
stocks associated with the Internet Bubble of 1990s

7.1 Cross Country Comparisons
 The countries with the lowest returns have
been those that experienced the most economic
upheaval.

Sloppy Economic Analysis
 Deviations are short-lived
 Focused on a particular segment of the economy
Managers are best off focusing their energy on long-term
value creation and not worrying about the latest stock
market trends.

Market Bubbles
When managers and market participants take their
eye off the fundamentals of long-term value
creation, market bubbles can result. Two main
bubble:
 The LBO Bubble
 The Internet Bubble

The LBO Bubble
 The emergence of high-yield bond financing opened the door for smaller
investors, known as leveraged-buyout (LBO) firms, to take a leading role
in the hostile-takeover game.
 LBO firms’ early successes attracted the attentions of other investors,
commercial bankers and investment bankers.
 LBO deals and high-yield debt continue to thrive and play and important
role in corporate restructuring and value creation

The Internet Bubble
 Many executives and investors forgot or purposely threw out fundamental
rules of economics in the rarified air of the Internet revolution.
 When the laws of economics prevailed, competition reined in returns in
most product areas.
 The Internet Bubbles shows what happens when manager, investors and
bankers ignore the fundamental principles of economics and the
underlying history of value creation.

11. Creating Value Leads To Healthier
Companies
 Companies dedicated to value creation are healthier and build stronger
economies, higher living standards, and more opportunities for
individuals
 United States and European companies that created the most
shareholder value in the past 15 years have shown healthier
employment growth

Companies with the highest total returns to shareholders (TRS) also
had the largest increases in employment.
Correlation between TRS and Employment growth

Companies that
emphasize creating value
for shareholders are not
shortsighted.
There is strong positive
correlation between
shareholder returns and
investments in research
and development (R&D).
Correlation between TRS and R&D Expenditures

12. Short-Term Earnings vs
Long-term Value Creation
 Managers are tempt to find ways to keep profits growing in the short-
run, while they try to stimulate longer-term growth
 Capital market reward companies that focus on long-term value creation
 Long-term value creating companies help the economy and other
stakeholders
 Stock market always assist on short-term results, putting pressure on
managers

13. Short-term Earnings vs
Long-term Value Creation (cont’d)
 It is up to managers to sort out the trade-offs between short-
term earnings and long-term value creation
 Managers should be responsive to changes and act
accordingly
 Corporate board needs to investigate and be active to judge
managers, so they choose the right trade-offs

Questions?

Chapter 2 on Valuation and Reporting in Organization

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