Summary of Valuation: Measuring and Managing the Value of Companies, 4th Edition

Written by: Tim Koller, Marc Goedhart, David Wessels

Summary written by: Travis Cocke

Why Maximize Value? Markets Track Economic Fundamentals

The U.S. stock markets behavior from 1980 through 2004 confused and frustrated investors and fund
managers. For roughly 20 of those years, the market was extremely bullish as the S&P 500 index rose from a
level of 108 in January 1980 to 1469 in December 1999. Including dividends, the nominal annual return to
shareholders was 17%, or 13% after adjusting for inflation, more than double the 6.5% average annual return
that stocks have delivered over the past 100 years. By early 2000, many investors had come to expect
consistently high returns from equity investing. Then the market fell abruptly, falling more than 30% over the
next three years. Such a large run-up, followed by such a sharp decline, led many to question whether the stock
market was anything more than a giant roulette table, essentially unconnected to the real world. Overall, the
market tracks expected fundamental fairly closely. Deviations from long-term economic fundamentals are
usually short-lived, focus on a particular segment of the economy (sector bubbles and panics), or both.
Managers are therefore better off focusing their energy on long term value creation and not worrying about the
latest stock market trends. When managers and market participants take their eye off of the fundamentals of
long term value creation is when market bubbles can result. Companies dedicated to value creation are healthier
and build stronger economies, higher living standards and more opportunities for individuals and capital
markets reward them for it. Unfortunately, managers are often under pressure to achieve short term results at the
expense of long-term value creation. In a recent survey of 400 executives, 55% of them said they would delay
or cancel a value-creating project to avoid missing the consensus analysts forecast for the current quarters
earnings. The pressure to show short term results often occurs as a company matures and transitions from high
to low growth. Managers are tempted to find ways to keep profits growing in the short term which makes
achieving long term growth much more difficult.
The Value Manager
Value managers are a special breed: They focus on long term cash flow rather than on quarter-to-quarter
earnings. They judge businesses by returns above opportunity costs, not by size, prestige, and other emotional
issues. A few ways to enhance shareholder value are to develop value oriented targets and performance metrics,
tie compensation to value creation, review business performance and develop an investor communications
strategy.
Fundamental Principles of Value Creation
Investing in the stock market is like betting on a sports team, but with a point spread. When a spread exists, you
cannot just pick the team you expect to win, you have to beat the spread (if you pick the favored team, the
favored has to win by more points than the spread for the bet to pay off). Thus, picking a good team is not
enough. The team has to beat expectations. The return that investors earn is driven not by just the performance
of the company, but by the performance relative to expectations. If a company creates lots of value in the real
market but do not do as well as investors expect, investors will be disappointed. The task of a manager is to
maximize the intrinsic value of the company and to properly manage the expectations of the financial market.
Total returns to shareholders are driven by performance against expectations and not absolute levels of
performance. For example, on July 13, 2004, Intel reported a second quarter net income of $1.76 billion, almost
double what it had reported for that period a year earlier, nevertheless, Intels shares declined by 11% on the
day of the announcement. This is likely because its sales and margins, considered important indicators of long
term profitability in the sector, were below the markets expectations. Over long time periods total shareholder

Downloaded from www.hvst.com by IP address 113.193.154.252 on 2016/11/26

returns will be linked to earnings, because over the long term, earnings growth will track cash flows. There is a
strong relationship between total shareholder return and changes in performance expectations, however, there is
almost no relationship between returns and the various absolute cash flow or economic profit measures.
Five important lessons of creating and measuring value:
1.) In the real market you create value by earning a return on your invested capital greater than the
opportunity cost of capital
2.) The more you can invest at returns above the cost of capital, the more value you create.
3.) Managers should select strategies that maximize the present value of expected cash flows or economic
profit.
4.) The value of a companys shares in the stock market is based on the markets expectations of future
performance (which can deviate from intrinsic value if the market is less than fully informed about the
companys true prospects).
5.) After an initial price is set, the returns that shareholders earn depend more on the changes in
expectations about the companys future performance than the actual performance of a company. For
example, if a company is expected to earn 25% on its investments, but only earns 20%, its stock price
will drop, even though the company is still earning more than its cost of capital.

The Intuition behind Discount Cash Flow Analysis

The following table shows the projected earnings for two companies, Aggie, Inc. and Longhorn, Inc.:
Earnings
Aggie, Inc.
Longhorn, Inc.

1
$100.0
$100.0

2
105
105

3
110.3
110.3

4
115.8
115.8

5
121.6
121.6

Since the future earnings of both companies are identical you might think that they are worth the same, but
earnings can be misleading. It is necessary to examine how each company generated its growth. Following is
the projected cash flow for the two companies:
Year
Aggie, Inc.
Earnings
Net Investment
Cash Flow

1
$100.0
25.0
$75.0

2
$105.0
26.2
$78.8

3
$110.3
27.6
$82.7

4
$115.8
29
$86.8

5
$121.6
30.4
$91.2

2
$105.0
52.5
$52.5

3
$110.3
55.1
$55.1

4
$115.8
57.9
$57.9

5
$121.6
60.8
$60.8

Year
Longhorn, Inc.
Earnings
Net Investment
Cash Flow

1
$100.0
50.0
$50.0

Aggie, Inc.s cash flows are higher than Longhorn, Inc.s despite identical profits because it invests less than
Longhorn, Inc. to achieve the same profit growth. Aggie, Inc. invests 25% of its profits, whereas Longhorn, Inc.
must invest 50% of its profits to generate the same profit growth. If we assume that both companies have
similar risk, we can discount their cash flows at the same discount rate, say 10%. If both continue to grow cash
flow at 5%, we can use the growing free cash flow perpetuity formula to value each company

Downloaded from www.hvst.com by IP address 113.193.154.252 on 2016/11/26

*This formula assumes that companys cash flow will grow at a constant rate forever.

Using the formula we can compute the value of Aggie, Inc. to be $1,500 and Longhorn, Inc. to be $1,000. We
can then find an implied earnings multiple by dividing their value by their current earnings. Aggie, Inc. has an
earnings multiple of 15 and Longhorn, Inc. of 10. So despite having identical earnings and earnings growth,
they have different earnings multiples. This highlights the flaws with relative valuation methods such as
earnings multiples. You might have estimated Longhorn, Inc.s value by multiplying Aggie, Inc.s multiple and
Longhorn, Inc.s earnings if you had not forecasted cash flows. That would clearly overstate Longhorns value.
Relative value methods do not value directly what matters to investors. The DCF model accounts for the
difference in value by factoring in the capital spending and other cash flows required to generate earnings.

Drivers of Cash Flow and Value

There are two key drivers of cash flow and ultimately value: the rate at which the company can grow its
revenues and profits, and its return on invested capital (relative to 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.
A companys growth rate is the product of its return on new capital and its investment rate (net investment
divided by operating profits).
Growth rate = Return on New Invested Capital x Investment Rate
A company with an already high ROIC will create more value by increasing growth rather than by earning an
ever higher ROIC. Conversely, companies with a low ROIC create more value by increasing ROIC.
Key Value Driver Formula:
This is the key value driver formula because it relates a companys value to the fundamental drivers of
economic value: growth, ROIC, and the cost of capital. ROIC and growth drive earnings multiples.
DCF Equals the Present Value of Economic Profit
Economic profit measures the value created by a company in a single period and is defined as follows:
Economic Profit = Invested Capital x (ROIC WACC)
Stated another way, economic profit equals the spread between the ROIC and the cost of capital times the
amount of invested capital. An advantage of the economic profit model over the DCF model is that economic
profit is a useful measure for understanding a companys performance in any single year, whereas free cash
flow is not. For example, you would not track a companys progress by comparing actual and projected free
cash flow because free cash flow in any year is determined by discretionary investments in fixed assets and

Downloaded from www.hvst.com by IP address 113.193.154.252 on 2016/11/26

working capital. Management could easily improve FCF in any given year at the expense of long-term value
creation by delaying investments. Economic profit translates size, return on capital, and cost of capital into a
single measure. The above formula for economic profit can be rearranged and defined as after-tax operating
profits less a charge for the capital used:
Economic Profit = Net Operating Profit Less Adjusted Taxes (Invested Capital x WACC)
*Note that if a company earned exactly its WACC every period, then the discounted value of its projected FCF should exactly equal its invested
capital- since no value is created by the company it is worth exactly what is originally invested.*

Economic Profit and the Key Value Driver Formula:

According to this formula, a companys enterprise value equals the book value of its invested capital plus the
present value of all future economic profits. Note that if the expected economic profits are zero going forward,
the value of a company equals its book value. In addition, if economic profits are expected to be less than zero
in the future, then enterprise value should trade at less than book value of invested capital.

Do Fundamentals Really Drive the Stock Market?

Although some stocks, in some sectors, can be driven in the short run by irrational behavior, the stock market as
a whole follows fundamental laws grounded in economic growth and returns on investment:

Companies with higher returns and higher growth have richer valuations in the stock market
To value stocks, markets primarily focus on the long-term and not short-term
Share price depends on long-term returns, not short-term EPS performance
Markets are capable of seeing the economic fundamentals behind accounting information
Market-wide price deviations from fundamentals can occur, but they are the exception, not the rule. In
the late 1970s, prices were too low as investors were overly obsessed with high short-term inflation
rates. In the late 1990s, market prices reached excessive levels that could not be justified by the
underlying economic fundamentals
When the market undergoes a period of irrational behavior, smart managers can detect it and exploit the
deviations

The market seems to value companies based on revenue growth and ROIC. Evidence shows that the stock
market does not reward companies that pursue growth without covering their cost of capital.
Market Focuses on Long Term Rather Than Short Term
A quick look at the high values for companies without any near-term earnings (such as biotech) indicates that
the market takes a long term view. In the late 1990s, the stock markets long term view was certainly
demonstrated in the ascent of the internet stocks, based on companies without concrete products, let alone
profits. That time though, the market was wrong; long term earnings never materialized for many internet
companies. Nonetheless, the market did not narrowly focus on near term earnings when
valuing these companies. Missing or beating short term EPS targets by itself does not lead to large price swings.
In many cases, however, investors have only short term results by which to gauge longer term corporate
performance. Investors can interpret a recent EPS target miss as an omen of long term performance declines or
loss of management credibility. If management can convince the market that poor short term earnings will not

Downloaded from www.hvst.com by IP address 113.193.154.252 on 2016/11/26

affect long-term profitability or growth, then the share price need not fall after a target miss. For the most part,
share price reactions to EPS numbers have nothing to do with short termism, but rather involve real changes in
long term prospects. For example, in the pharmaceutical industry, announcements relating to products under
development can affect share prices far more than quarterly earnings announcements. Products and pipeline
development are much better indicators of the long term growth and profitability of pharmaceutical companies
than short term earnings and the markets understand this well. Also, the markets see fundamentals behind
accounting information. Investors are not interested in accounting choices; investors care about underlying
performance and long term cash flows must justify the share prices.

Deviations from Intrinsic Value

Significant deviations from intrinsic value rare and markets eventually revert back to the economic
fundamentals thus mangers should continue to base their decision making on DCF analyses. By and large the
stock markets in the developed economies have been fairly priced and have oscillated around their intrinsic
price-to-earnings ratios.
Key Conditions for Market Deviations:
1.) Irrational investor behavior. Irrational investors do not process all available information correctly when
forming expectations on the stocks future performance. For example, individual investors overreact and
attach too much emphasis to recent events and results.
2.) Systematic patterns of behavior across different investors. When groups of investors behave irrationally
in a systematic way (when large groups share particular patterns of behavior) persistent price deviations
may occur.
3.) Limits to arbitrage in financial markets. In reality perfect arbitrage is not always possible.
*An argument of Eugene Fama for market efficiency is that there is no systematic way to
predict when markets will over or under-react*

While in certain cases, deviations from intrinsic value can persist for months or even a few years, there
ultimately will be sufficient liquidity from rational investors for stock prices to revert back to their fundamental
values.
Implications of Market (In)Efficiency for Corporate Managers
Corporate managers can benefit from intrinsic value deviations by better timing the implementation of strategic
decisions, such as:
Issuing additional share capital at times when the stock market is attaching too high a value to the
companys shares relative to intrinsic value
Repurchasing shares when the stock market under prices them
Divesting particular businesses at times when trading and transaction multiples in that sector are higher
than can be justified by underlying fundamentals

Downloaded from www.hvst.com by IP address 113.193.154.252 on 2016/11/26

Frameworks for DCF-Based Valuation

Valuing Operations
Free Cash Flow equals the cash flow generated by the companys operations, less any reinvestment back into
the business. FCF is the cash flow available to all investors, and is independent of leverage. Consistent with
definition, FCF must be discounted using the weighted average cost of capital. The WACC is the companys
opportunity cost of funds and represents a blended required return by the companys debt and equity holders.
Thinking about ROIC and Growth: A companys value depends on its ROIC and its ability to grow; all other
considerations are just details.

This version of ROIC is identical to the traditional definition of NOPLAT divided by invested capital. However,
the ratio is segmented into taxes (T), revenue and cost per unit, as well as quantity, to highlight the potential
sources of value creation that you should consider when valuing a company. The formula generates a series of
questions: Can the company charge a price premium for its products or services? Does the company have lower
unit costs than its competition? Can the company sell more products per dollar invested capital? To justify high
future ROICs in financial projections, you must identify at least one source of competitive advantage.
To generate a high value, a company must not only excel at pricing power, cost competitiveness, or capital
efficiency, but also must be able to sustain this competitive advantage over long periods. Economic theory
dictates that companies earning returns in excess of their cost of capital will invite competition. If the company
cannot prevent competition from duplicating its efforts, high ROIC will be short-lived, and the companys value
will be lowered.
When companies are earning returns in excess of their cost of capital (or are even losing money), you must
assess two questions: (1) How long will it take before the company starts creating value? And (2) How large
will the initial investments or losses be?
Developing an accurate revenue growth forecast is critical to valuation. Dont be overly optimistic in your
forecast: growth eventually slows, as with ROIC, strong growth at high returns on capital attracts competition.
Also, as a company grows, its revenue base increases and growing at 20% on $100 billion of revenue is much
harder than growing at 20% on a base of $100 million. Remember, a company that grows at 20% will double in

Downloaded from www.hvst.com by IP address 113.193.154.252 on 2016/11/26

size in less than four years. Growth at this rate places many demands on the company and its management,
making future growth more difficult.
A valuation based on DCF is only as good as the models forecasts. Dont get too caught up in the details of a
companys financial statements and forget the economic fundamentals: A companys value is driven by growth
and ROIC. When you are performing a valuation it is critical to evaluate how your forecasts of ROIC and
growth relate to the economics of the industry and how your results compare with historical performance of
companies that came before. If you plan to forecasts large returns on capital and high growth levels, make sure
you can explicitly point to a companys source of competitive advantage, and in addition make sure those
assumptions are within a reasonable historical bound.

Analyzing Historical Performance

To analyze a companys historical performance:
Reorganize the financial statements to reflect economic value, instead of accounting, performance (e.g.
look at NOPLAT and FCF).
Measure and analyze the companys ROIC and economic profit.
Break down revenue growth into four components: organic growth, currency effects, acquisitions, and
accounting changes.
Assess the companys financial health and capital structure to determine whether it has the financial
resources to conduct business and make short and long term investments.
To properly ground your historical analysis, you need to separate operating performance from non-operating
items and the financing obtained to support the business. The resulting measures, ROIC and FCF, are
independent of leverage and focus solely on the operating performance of a business. To build FCF and ROIC,
you must organize the balance sheet to create invested capital and likewise must reorganize the income
statement to create net operating profit less adjusted taxes (NOPLAT). NOPLAT represents the total after-tax
operating income that is available to all financial investors.
An Example of NOPLAT:
$ million
Accountant's Income Statement
Current Year
Revenues
1000
Operating Costs
(700)
Depreciation
(20)
Operating Profit
280

NOPLAT
Current Year
1000
(700)
(20)
280

Revenues
Operating Costs
Depreciation
Operating Profit

Taxes are calculated on

Interest
Nonoperating Income
Earnings before Taxes
Taxes
Net Income

(20)
4
264
(66)
198

Operating Taxes
NOPLAT

operating profits.
Do not include income

After-tax nonoperating Inc 1

Total Inc to all Investors

3
213

from any asset excluded

from invested capital as
part of NOPLAT.

Reconciliation with Net Inc

Net Income
After-tax Interest 1
Total Inc to all Investors
1

(70)
210

198

Treat interest as a

15
213

financial payout to

Assumes a flat tax of 25% on all income.

Downloaded from www.hvst.com by IP address 113.193.154.252 on 2016/11/26

investors, not an expense.

Building an economic balance sheet:

Operating Assets Operating Liabilities = Invested Capital = Debt + Equity
Notes: Non-operating assets include excess cash and marketable securities, illiquid investments, nonconsolidated subsidiaries, and other equity investments, prepaid and intangible pension assets. Equity includes
common stock, additional paid-in capital, retained earnings, and accumulated other comprehensive income
(AOCI). Any stock repurchased and held in treasury should be deducted from total equity.
Free Cash Flow: Key Concepts
FCF is independent of financing and non-operating items. It can be thought of as the after-tax cash flowas if
the company held only core operating assets and financed the business entirely with equity. FCF is defined as:
FCF=NOPLAT+Noncash Operating ExpensesInvestments in Invested Capital
Invested Capital equals operating assets minus operating liabilities. Total funds invested equals invested capital
plus non-operating assets.
Hidden Assets
Two items that accountants fail to capitalize are operating leases and research and development. If these hidden
assets are significant, include the value of the leases in operating assets, with a corresponding debt recorded as a
financing item. Otherwise, companies that lease assets will appear capital light relative to identical companies
that purchase the assets. If possible, R&D should be capitalized and amortized in a manner similar to capital
expenditures.
Analyzing ROIC
Since it focuses solely on a companys operations, ROIC is a better analytical tool for understanding a
companys performance than ROE and ROA. ROE mixes operating performance with capital structure
decisions, making peer group analysis and trend analysis less meaningful. Return on assets is inadequate
because the ratio double counts any implicit financing charged by suppliersin the numerator as a part of costs
of goods sold and in the denominator as part of total assets. ROIC should be computed both with and without
goodwill. If the company does not properly compensate investors for the funds spent (or shares given away), it
will destroy value (in acquisitions). Thus, when you measure historical performance for the companys
shareholders, ROIC should be measured with goodwill. Conversely, ROIC excluding goodwill measures the
companys internal performance and is useful comparing operating performance across companies for analyzing
trends. To better understand ROIC, split apart the ratio as follows:
ROIC= (1-Cash Tax Rate) x

EBITDA
x
Revenues

Revenues
Invested Capital

This equation demonstrates that a companys ROIC is driven by its ability to maximize profitability (operating
margins), optimize capital efficiency (turns), or minimize taxes. From there, each of these components can be
further disaggregated into their respective components, so that each expense and capital item can be compared
with revenues. For example, pretax ROIC equals operating margin times capital turnover, and operating margin
equals gross margin less SG&A/revenue less depreciation/revenues. A manager has some control over these
operational drivers. Once you have calculated the historical value drivers, compare them to the drivers of other
companies in the same industry. Integrate this perspective with an analysis of the industry structure
(opportunities for differentiation, entry/exit barriers, etc.) and a qualitative assessment of the companys

Downloaded from www.hvst.com by IP address 113.193.154.252 on 2016/11/26

strengths and weaknesses. One disadvantage of ROIC is that is measured as a percentage. It does not
incorporate the magnitude of value creation. To overcome this, use economic profit, which converts ROIC into
a dollar measure.
Line Item Analysis
A comprehensive valuation model will convert every line item in the companys financial statements into some
type of ratio. For the income statement, most items are taken as a percentage of sales. For the balance sheet,
each line item can also be taken as a percentage of sales or cost of goods sold. For operating current assets and
liabilities, you can convert each line item into days using this formula:
Analyzing Revenue Growth
Calculating revenue growth directly from the income statement will suffice for most companies. Year to year
growth results can sometimes be misleading, however, due to the effects of currency translations, mergers and
acquisitions, and changes in accounting policies. If foreign currencies are rising in value relative to the
companys home currency, this translation, at better rates, will lead to higher revenue numbers. Once these
effects have been removed from the year-to-year revenue growth numbers, try to analyze the growth from an
operational perspective. The most standard breakdown is:

Using this formula, determine whether prices or quantities are driving growth.
Credit Health and Capital Structure
To determine how aggressive a companys capital structure is, you should look at two related but distinct
concepts: liquidity (via coverage) and leverage. Liquidity measures the companys ability to meet short-term
obligations, such as interest expenses, rental payments, and required principal payments. Leverage measures the
companys ability to meet obligations over the long term.
Liquidity measures: EBITDA/ interest or EBITA/ interest or Net Debt/EBITDA
EBITA to interest measures the companys ability to repay interest using profits without having to cut
expenditures intended to replace depreciating equipment. EBITDA to interest measure the companys ability to
meet short term commitments using both current profits and the depreciation dollars earmarked for replacement
capital.
Leverage: To assess leverage, measure the companys (market) debt-to-equity ratio over time and against peers.
Leverage = Debt/ Debt + Equity
General Considerations for Historical Analysis

Look back as far as possible. Long time horizons allow you to determine whether the company and
industry tend to revert to some normal level of performance, and whether short-term trends are likely to
be permanent.
Disaggregate the value drivers, both ROIC and revenue growth, as far as possible. If possible, link
operational performance measures with each key value driver.

Downloaded from www.hvst.com by IP address 113.193.154.252 on 2016/11/26

If there are any radical changes in performance, identify the source. Determine whether the change is
temporary or permanent, or merely an accounting effect.

Forecasting Performance
Determine the Length and Detail of the Forecast
The explicit forecast period should be long enough for the company to reach a steady state, defined by these
characteristics:
The company grows at a constant rate and reinvests a constant proportion of its operating profits into the
business each year
The company earns a constant rate of return on new capital invested
The company earns a constant return on its base level of invested capital
The growth rate becomes less than or equal to that of the entire economy
As a result, FCF will grow at a constant rate and can be valued using a growth perpetuity. To simplify the
model and avoid the error of false precision, split the forecast into two periods:
(1) A detailed five-to-seven year forecast, which develops complete balance sheets and income statements
with as many links to real variables as possible
(2) A simplified forecast for the remaining years, focusing on few important variables, such as revenue
growth, margins and capital turnover
Mechanics of Forecasting
1.
2.
3.
4.
5.
6.

Prepare and analyze historical financials

Build the revenue forecast
Forecast the income statement
Forecast the balance sheet: invested capital and non-operating assets
Forecast the balance sheet: investor funds
Calculate ROIC and FCF

Estimating Continuing Value (aka Terminal Value)

Continuing value: the value of the companys expected cash flow beyond the explicit forecast period. Making
simplifying assumptions about the companys performance during this period, we can estimate the value by
using formulas instead of forecasting and discounting cash flows over an extended period. Often continuing
value is a large portion of overall value because profits and other inflows in the early years are offset by outflow
for capital expenditures and working capital investmentinvestments that should generate higher cash flow in
later years.

Where NOPLAT t+1 = Normalized level of NOPLAT in the first year after the explicit forecast period
g= Expected growth rate in NOPLAT in perpetuity
RONIC= Expected rate of return on new invested capital

Downloaded from www.hvst.com by IP address 113.193.154.252 on 2016/11/26

Estimating the Cost of Capital

To value a company using enterprise DCF, you must discount the FCF by the WACC. The WACC represents
the opportunity cost that investors face for investing their funds in one particular business instead of others with
similar risk. To assure consistency, the cost of capital must meet several criteria:
It must include the opportunity costs from all sources of capitaldebt, equity, and so onsince FCF is
available to all investors, who expect compensation for risks they take.
It must weight each securitys required return by its target market-based weight, not by its historical
book value.
It must be computed after taxes (since FCF is calculated in after-tax terms). Any financing-related tax
shields not included in FCF must be incorporated into the cost of capital or valued separately.
It must be denominated in the same currency as FCF.
It must be denominated in nominal terms when cash flows are stated in nominal terms.
To determine the WACC, calculate its three components: the cost of equity, after-tax cost of debt, and target
capital structure. None of these variables are directly observable and require assumptions and approximations.

Where D/V = Target level of debt to enterprise value using market-based (not book) values
E/V = Target level of equity to enterprise value using market-based values
K d = Cost of debt
K e = Cost of equity
T m = Companys marginal income tax rate
For companies with other securities, such as preferred stock, additional terms must be added to the cost of
capital. To determine the cost of equity, we rely on the capital asset pricing model (CAPM), one of many
theoretical models that convert a stocks risk into expected return. The CAPM uses three variables to determine
a stocks expected return: the risk-free rate, the market risk premium, and the stocks beta. To approximate the
cost of debt, use the companys yield to maturity on its long term debt (or use a similar companys Kd). Since
FCF is measured without interest tax shields, measure the cost of debt on an after-tax basis. Weight these costs
using target levels of debt to value and equity to value. For mature companies, the target capital structure is
often approximated by the companys current debt-to-value ratio, using market values of debt and equity.
Think of discounted cash flow this way: A portion of future cash flows is required to cover the required return
for the investors capital. The remaining cash flow is either used to grow invested capital or is returned to
investors as an extra bonus. This bonus is valuable, so investors desire cash flows above the amount required.
Subsequently, companies with positive economic profits will trade at a premium to the book value of invested
capital.
Capital Asset Pricing Model
The CAPM postulates that the expected rate of return on any security equals the risk-free rate plus the securitys
beta times the market risk premium (estimated between 4.5-5.5%):
Where E(Ri) = Security is expected return
Rf = Risk-free rate (10-year treasury)
Bi = Stocks sensitivity to the market
E(Rm) = Expected return of the market

Downloaded from www.hvst.com by IP address 113.193.154.252 on 2016/11/26

Using Multiples for Valuation

To apply multiples properly, use the following four best practices:
1. Choose comparables with similar prospects for ROIC and growth.
2. Use multiples based on forward-looking estimates.
3. Use enterprise-value multiples based on EBITA to mitigate problems with capital structure and
one-time gains and losses.
4. Adjust the enterprise-value for non-operating items, such as excess cash, operating leases,
employee stock options, and pension expenses (the same items for which you adjust ROIC and
FCF).
You must then answer the question: Why are the multiples different across the peer group? If some companies
have strategic advantages that translate into higher ROIC and growth rates then they should trade at higher
multiples. When building a multiple, the denominator should always use a forecast of profits rather than
historical profits. Forward looking multiples are more accurate predictors of value and are consistent with the
principles of valuationin particular, that a companys value is equal to the present value of future cash flow,
not sunk costs. The price to earnings multiple has two major flaws. First, the P/E ratio is systematically affected
by capital structure decisions. Secondly, unlike EBITA, net income is calculated after non-operating gains and
losses. Thus, a non-operating loss, such as a non-cash write-off, can significantly lower earnings (without a
comparable effect on value), causing the P/E ratio to be artificially high.

PEG Ratios
Traditionally, PEG ratios are calculated by dividing the P/E ratio by expected growth in earnings per share, but
this modified version is based on the enterprise-value multiple:
Adjusted PEG Ratio = 100 x (Enterprise-Value Multiple/ Expected EBITA Growth Rate)
The PEG ratios ability to analyze companies with varying growth appears to give it a leg up on the standard
enterprise-value multiple. Two drawbacks of the PEG ratio are (1) there is no standard time frame for
measuring expected growth and (2) it assumes a linear relationship between multiples and growth, such that no
growth implies zero value.
Never view multiples as a shortcut. Instead, approach your multiples analysis with as much care as you would
DCF analysis.
Performance Measurement

Corporate
Health

Performance

Short term

Growth

Medium term

Capital Markets Value/Returns to Shareholders

Value of
discounted
cash flow

ROIC
Long term
Organizational

Intrinsic
Value

Cost of
Capital

Downloaded from www.hvst.com by IP address 113.193.154.252 on 2016/11/26

Performance measurement can be organized around three questions:

1.) Historically, how much value has the company created (as measured by their financial statements)?
2.) How well positioned is the company to create additional economic value in the future, and what risks
may prevent this value creation?
3.) Is the companys current market value in line with its historical performance and potential economic
value creation? What accounts for recent changes in its stock price?
The first question addresses historical financial performance. Financial metrics that can be linked directly to
value creation are more meaningful than traditional accounting metrics, like EPS.
The second question addresses the companys health by examining the underlying drivers of a companys
financial performance. Specifically, how did the company achieve its recent financial results, and did the
company sacrifice future performance to achieve those results? As a final assessment of corporate performance,
check the stock price. Examining it without the proper context can easily lead to mistaken impressions. For
instance, an oil companys stock price rising can reflect higher oil prices, rather than management decisions on
exploration techniques. A board of directors that is complacent with strong price performance caused by factors
outside of their control will all too quickly despair when the outside factors eventually turn against the
company.

Short-term Health Metrics

1.) Sales productivity
2.) Operating cost productivity
3.) Capital productivity
Medium-term Metrics
1.) Commercial health: product pipeline, brand strength, customer satisfaction, etc.
2.) Cost structure health: ability to manage costs relative to peers over three to five year.
4.) Asset structure health: how well a company maintains and develops assets.
Organizational Health: People, skills, culture.

Performance Management
Successful performance management includes some important ingredients:
Complete buy-in at all levels on the priority and mind-set of value creation.
Clarity on which value drivers are fundamental to the performance and health of the business
A target and aspiration setting process that provides real challenge and builds commitment
A fact based performance review process that balances short-term performance and growth
A strong link to accountability and the process of evaluating people
Value Drivers and Value Metrics
A value driver is an action that affects business performance in the short or long term and thereby creates value.
To measure how well the business is performing in relation to these value drivers, companies use a mix of value
metrics and value milestones. Metrics measure quantitatively how well the business is doing in terms of a
driver, for example the addition of new space for a retailer. Another way to measure progress of a value driver
is to use milestones, such as closing acquisitions. The relative importance of different value drivers in a
particular industry depends on its fundamental microeconomics. For instance, improving customer loyalty

Downloaded from www.hvst.com by IP address 113.193.154.252 on 2016/11/26

matters much more in branded consumer goods than it does in chemicals. A benefit of having clear value
drivers is that it enables management teams to assign priorities to actions.
Developing Value Drivers and Value Metrics
Questions to ask to filter out a businesss key value drivers:
Is the value driver material?
How much impact can the business have on the driver?
Have unintended consequences been considered?
Is the driver sustainable?

Creating Value Through M&A

There are four main sources of synergies from mergers and acquisitionshigher margins, increased capital
efficiency, higher growth, and lower cost of capital. Cost reduction synergies are usually estimated fairly well.
Revenue synergies are consistently overestimated. To create a true synergy, the transaction has to enable one or
both of the companies to grow faster than originally expected. Many companies have difficulty even
maintaining the baseline revenue growth rate because a portion of the combined companys customers leave
due to uncertainty. Be skeptical of synergy estimates that stem from a perceived lower cost of capital.
Combining companies may smooth earnings, but since investors can already diversify their own portfolios,
combining companies will not lower the aggregate risk they face. Optimizing the targets capital structure to
either reduce taxes or lower financial distress costs may provide some value but should never be the deciding
factor. Synergies not captured within the first full budget year after consolidation may never be captured, as the
circumstances are overtaken by subsequent events. In a recent study, McKinseys Post-Merger Management
practice found a direct correlation between the speed of execution and the ability to capture estimated synergies.
After a transaction it is important that executives manage the integration process carefully, moving as quickly as
possible to capture the synergies that may soon disappear.

Creating Value through Divestitures

Evidence shows that divestitures create value for corporations, both in the short term, around their
announcement, and in the long term. Furthermore, companies employing a balanced portfolio approach of both
acquisitions and divestitures have outperformed companies that rarely divested. Most managers shy away from
divestitures, because from their point of view portfolio expansion is a clearer sign of success. It is not
surprising then that a change in corporate leadership is one of the key triggers for divestitures. Divestitures
create value when the business unit is worth more to some other owner or in some other ownership structure.
Business units can be worth more in another ownership structure because the current one may impose unique
costs on the parent or unit. Although divesting underperforming businesses avoids the direct costs of bearing the
deteriorating results, divesting profitable and growing divisions can also benefit both the parent and the business
unit. In these situations, a divestiture may create value because the subsidiary will become more competitive,
due to increased freedom for tailored financing and investment decisions, improved management incentives, or
better overall focus. Companies that hold onto seriously underperforming businesses too long risk bringing
down the value of the entire corporation. By the time the company is forced to conduct a fire sale of the assets,
it has already destroyed substantial value and generally will receive limited proceeds from the divestiture. As
businesses become more mature and competitive challenges increase, the level of expected future value creation
generally declines.

Downloaded from www.hvst.com by IP address 113.193.154.252 on 2016/11/26

Alternative Forms of Divestitures

Private Transactions
Trade Sale: sale of part of all of a business to a strategic or financial investor
Joint Venture: combining part or all of a business with other industry players, other companies in the
value chain, or venture capitalists
Public Transactions
Initial Public Offering: sale of all shares of a subsidiary to new shareholders in the market
Carve-out: sale of part of the shares in a subsidiary to new shareholders
Spin-off: distribution of all shares in a subsidiary to existing shareholders of the parent
Split-off: an offer to existing shareholders of the parent company to exchange their shares in the parent
company for shares in the subsidiary
Tracking stock: separate class of parent shares that is distributed to existing shareholders of the parent
company through a spin-off or sold to new shareholders through a carve-out
In most cases, companies should choose private transactions if they can identify other parties that are better
owners of the business. Private transactions allow the company to sell the business unit at a premium and
capture value immediately. Note that all of the public transactions in the preceding list involve the creation of a
new public security, but not all of them actually result in cash proceeds. Full IPOs and carve-outs result in cash
proceeds as securities are sold to new shareholders. Many spin-offs are executed in two steps: a minority IPO
(carve-out) followed by a full spin-off shortly thereafter. Spin-offs typically meet or exceed expectations for
value creation. Analysis of parent and subsidiary performance of a sample of spin-off transactions shows that
the operating margins of spin-off subsidiaries improves by one-third during the three years after completion of
the transaction. If a company does not want to give up control of a division, it should consider a minority carveout.

Capital Structure
Careful design and management of a companys capital structure does more to prevent value destruction than to
boost value creation. Although academic researchers have investigated the issue for decades, there is still no
clear model for a companys optimal leverage ratio. The most obvious benefit of debt versus equity is the
reduction of taxes, since interest charges for debt are tax deductible. The so called free-cash-flow hypothesis
argues that debt can help impose investment discipline on managers. But higher levels of debt also give rise to
costs, most notably the legal and administrative costs of bankruptcy. Is there an optimal capital structure? The
answer is not as critical for shareholder value as some practitioners think. Managers can find meaningful
indicators of an effective capital structure, that is, a structure that is hard to improve on in terms of creating
shareholder value.
Credit Ratings and Capital Structure
Most companies have a credit rating in the range of A+ to BBB-, roughly corresponding to coverage ratios of 5
to 11 times interest. Credit rating estimates are important for a few reasons:
1. Ratings are a useful summary indicator of capital structure health; lower ratings reflect higher default
probabilities.
2. Ratings largely determine the companys access to the debt markets.
3. Ratings are nowadays important elements in the communication to shareholders
For industries with higher volatility of EBITDA, the coverage requirements are higher to attain a given credit
rating. Higher volatility implies a higher probability that a company will lack sufficient cash flow to service its

Downloaded from www.hvst.com by IP address 113.193.154.252 on 2016/11/26

interest commitment in the future. Although leverage and coverage ratios all point in the same direction, interest
coverage targets are more appropriate for setting long-term capital structure targets. One reason is that coverage
measures credit quality more accurately. A company should develop a capital structure that is robust enough
that a business downturn will not endanger the companys stability:
Step 1: Project financing surplus or deficit- project FCF and financing cash flows.
Step 2: Set target credit rating and ratios- determine the credit rating the company would like.
Step 3: Develop capital structure for base case scenario- determine uses and sources of FCF from operations.
Step 4: Test capital structure under downside scenario- construct downside scenarios, where margins are cut in
half for the next five years, for example.
Step 5: Decide on current and future actions- set the short and long term financing plan.
Signaling Effects from Capital Structure Decisions
For listed companies, the complication with capital structure decisions is that they send the capital markets
signals about a companys prospects. Consider three ways to resolve funding shortages: cutting dividends,
issuing new equity, or issuing new debt. Cutting dividends naturally frees up funding for new investments, but
the market interprets this as a signal of lower future cash flows. As a result, share prices on average decline 9%
on the day a company announces dividend cuts or omissions. Issuing equity is also likely to lead to a drop in
share prices, because investors assume that management would only issue stock if shares are overvalued.
Investors interpret the issuance of new debt much more positively than equity offerings, as they take it to mean
that future cash flows will be sufficient. Just as for funding deficits, there are three basic ways to handle excess
cash: dividend increases, share repurchases or extraordinary dividends, and debt repayments. In general,
investors interpret dividend increases as great news about a companys long term outlook for future cash flows.
Buying back shares indicates that management believes the companys shares are undervalued and signals that
cash will sufficient enough for debt payments. Buybacks are most suitable for one-off cash distributions. Unless
a company needs to pay down debt to recover from financial distress, this typically does not meet with positive
stock market reactions.
Creating Value from Financial Engineering
Financial engineering is managing a companys capital structure for maximum shareholder value with financial
instruments beyond straight debt and equity. In general, companies can create much more value for
shareholders in their business activities than in financial engineering.
Derivatives- enable a company to transfer particular risks to third parties that can carry those risks at lower cost.
Derivatives can create shareholder value when carefully applied in specific cases, but are not relevant to all
companies.
Off-Balance-Sheet Financing-includes a wide rage of instruments such as operating leases, synthetic leases,
securitization, and project finance. These can create shareholder value if they enable companies to attract debt
funding on terms that would have been impossible to realize from traditional forms of debt.
Hybrid Financing- involves forms of funding that share some elements of both debt and equity, the most
common examples are convertible debt and convertible preferred stock. Convertibles can make sense when
investors or lenders differ from managers in their assessment of the companys credit risk.

Investor Communications
A compelling investment story has three key elements: aspirations, strategy, and evidence. Aspirations define
what the company wants to accomplish and should be described in financial terms and market terms. For

Downloaded from www.hvst.com by IP address 113.193.154.252 on 2016/11/26

example, a company could define aspirations for revenue growth, profit growth, returns on capital, market
share, etc. Strategy explains how the company will reach its aspirations, it should explain the companys
competitive advantages or unique corporate skills and how those will translate into value creation. Evidence
helps investors assess whether a companys strategy works to achieve the declared aspirations. Evidence is not
necessarily detailed disclosures, but it does include key success stories. Greater transparency through these three
elements is likely to cause tighter alignment between managements reasonable estimate of intrinsic value and
the companys stock price. Investors want transparency in financial reporting as wells as transparency of what
drives financial results. Reporting the underlying drivers of value in a clear manner is the most powerful way to
help investors accurately assess the value of a companys shares.

Downloaded from www.hvst.com by IP address 113.193.154.252 on 2016/11/26