Valuation: Measuring and Managing the Value of Companies

Valuation Measuring and Managing the Value of Companies
Contents
About the Authors
Preface
Acknowledgments
Part One. Foundations of Value
1. Why Value Value?
What Does It Mean to Create Shareholder Value?
Short-Termism Runs Deep
Shareholder Capitalism Cannot Solve Every Challenge
Can Stakeholder Interests Be Reconciled?
Consequences of Forgetting Value-Creation Principles
This Book
2. Finance in a Nutshell
The Early Years
A New Concept
Should Lily and Nate Try to Maximize ROIC?
Going Public
Expansion into Related Formats
Some Lessons
3. Fundamental Principles of Value Creation
The Relationship of Growth, ROIC, and Cash Flow
Balancing ROIC and Growth to Create Value
Some Examples
Implications for Managers
Economic Profit Combines ROIC and Size
Conservation of Value
Conserving Value: A Brief History
A Tool for Managers
The Math of Value Creation
Summary
4. Risk and the Cost of Capital
Cost of Capital Is an Opportunity Cost
Companies Have Little Control over Their Cost of Capital
Create Better Forecasts, Not Ad Hoc Risk Premiums
Decide How Much Cash Flow Risk to Take On
Decide Which Types of Risk to Hedge
Summary
5. The Alchemy of Stock Market Performance
Why Shareholder Expectations Become a Treadmill
The Treadmill’s Real-World Effects
Decomposing TSR
Understanding Expectations
Implications for Managers
6. Valuation of ESG and Digital Initiatives
A Common Framework
Environmental, Social, and Governance (ESG) Concerns
Revenue Growth
Cost Reductions
Reduced Regulatory and Legal Interventions
Employee Productivity Uplift
Investment and Asset Optimization
Digital Initiatives
Measuring the Value of Digitization
Paths to Improved Performance
Closing Thoughts
7. The Stock Market Is Smarter Than You Think
Markets and Fundamentals: A Model
Markets and Fundamentals: The Evidence
Decades of Consistent Returns
P/E Fundamentals
Higher Returns, Higher Value
Deviations from Fundamentals
Myths about Earnings
EPS Growth from Share Repurchases
Earnings from Mergers and Acquisitions
Write-Downs
Employee Stock Options
Different Accounting Standards
Myths about Earnings Management
Earnings Volatility
Meeting Consensus Earnings Estimates
Earnings Guidance
Myths about Diversification
Myths about Company Size
Myths about Market Mechanics
Index Membership
Cross-Listing
Stock Splits
Myths about Value Distribution
Summary
8. Return on Invested Capital
What Drives ROIC?
Competitive Advantage
Price Premium Advantages
Cost and Capital Efficiency Advantages
Network Economies
Sustaining Return on Invested Capital
Length of Product Life Cycle
Persistence of Competitive Advantage
Potential for Product Renewal
An Empirical Analysis of Returns on Invested Capital
ROIC Trends and Drivers
ROIC by Industry
Stability of ROIC
Effect of Acquisitions on ROIC
Summary
9. Growth
Drivers of Revenue Growth
Growth and Value Creation
A Hierarchy of Growth Scenarios
Choosing a Growth Strategy
Why Sustaining Growth Is Hard
Empirical Analysis of Corporate Growth
Growth Trends
Growth across Industries
Sustaining Growth
Summary
Part Two. Core Valuation Techniques
10. Frameworks for Valuation
Enterprise Discounted Cash Flow Model
Valuing Operations
Identifying and Valuing Nonoperating Assets
Identifying and Valuing Debt and Other Nonequity Claims
Valuing Equity
Economic Profit-Based Valuation Models
Adjusted-Present-Value Model
Valuing Free Cash Flow at Unlevered Cost of Equity
Valuing Tax Shields and Other Capital Structure Effects
Capital Cash Flow Model
Cash-Flow-to-Equity Valuation Model
Problematic Modifications to Discounted Cash Flow
Alternatives to Discounted Cash Flow
Multiples
Real Options and Replicating Portfolios
Summary
11. Reorganizing the Financial Statements
Reorganizing the Accounting Statements: Key Concepts
Invested Capital: Key Concepts
Net Operating Profit after Taxes: Key Concepts
Free Cash Flow: Key Concepts
Reorganizing the Accounting Statements: In Practice
Invested Capital: In Practice
Computing Total Funds Invested
Reconciling Total Funds Invested
Calculating NOPAT
Reconciliation to Net Income
Free Cash Flow: In Practice
Cash Flow Available to Investors
Reconciling Cash Flow Available to Investors
Advanced Issues
Operating Leases
Retirement Obligations Such as Pensions
Capitalized Research and Development
Other Advanced Adjustments
12. Analyzing Performance
Analyzing Returns on Invested Capital
Analyzing ROIC with and without Goodwill and Acquired Intangibles
Decomposing ROIC to Develop an Integrated Perspective of Company Economics
Analyzing Revenue Growth
Currency Effects
Mergers and Acquisitions
Accounting Changes and Irregularities
Decomposing Revenue Growth to Develop an Integrated Perspective of Growth Drivers
Credit Health and Capital Structure
Measuring Liquidity Using Coverage Ratios
Measuring Leverage
Payout Ratio
Valuation Metrics
General Considerations
13. Forecasting Performance
Determine the Forecast’s Length and Detail
Components of a Good Model
Mechanics of Forecasting
Step 1: Prepare and Analyze Historical Financials
Step 2: Build the Revenue Forecast
Step 3: Forecast the Income Statement
Step 4: Forecast the Balance Sheet: Invested Capital and Nonoperating Assets
Step 5: Reconcile the Balance Sheet with Investor Funds
Step 6: Calculate ROIC and FCF
Advanced Forecasting
Nonfinancial Operating Drivers
Fixed versus Variable Costs
Incorporating Inflation
Concluding Thoughts
14. Estimating Continuing Value
Recommended Formula for DCF Valuation
Two-Stage Continuing-Value Models
Continuing Value Using Economic Profit
Misunderstandings about Continuing Value
Why Forecast Length Doesn’t Affect a Company’s Value
Why Continuing Value Doesn’t Mark the End of Competitive Advantage
Why Value Isn’t Just from Continuing Value
Common Pitfalls
Erroneous Base-Year Extrapolation
Naive Overconservatism
Purposeful Overconservatism
Other Approaches to Continuing Value
Other DCF Approaches
Multiples
Asset-Based Valuations
Closing Thoughts
15. Estimating the Cost of Capital
Calculating the Weighted Average Cost of Capital
Estimating the Cost of Equity
Estimating the Market Return
Adjust for Industry/Company Risk
Estimating the After-Tax Cost of Debt
Yield to Maturity as a Proxy
Cost of Below-Investment-Grade Debt
Incorporating the Interest Tax Shield
Forecasting Target Capital Structure to Weight WACC Components
Current Capital Structure
Capital Structure of Peer Companies
Management’s Financing Philosophy
Estimating WACC for Complex Capital Structures
Closing Thoughts
16. Moving from Enterprise Value to Value per Share
The Valuation Buildup Process
Valuing Nonoperating Assets
Excess Cash and Marketable Securities
Investments in Nonconsolidated Companies
Loans to Other Companies
Finance Subsidiaries
Discontinued Operations
Excess Real Estate
Excess Pension Assets
Tax Loss Carryforwards
Valuing Interest-Bearing Debt
Valuing Debt Equivalents
Provisions
Leases
Unfunded Retirement Obligations
Contingent Liabilities
Valuing Hybrid Securities and Noncontrolling Interests
Convertible Securities
Employee Stock Options
Noncontrolling Interests by Other Companies
Estimating Value per Share
17. Analyzing the Results
Validating the Model
Is the Model Technically Robust?
Is the Model Economically Consistent?
Are the Results Plausible?
Sensitivity Analysis
Assessing the Impact of Individual Drivers
Analyzing Trade-Offs
Creating Scenarios
The Art of Valuation
18. Using Multiples
Value Multibusiness Companies as a Sum of Their Parts
Use Forward Earnings Estimates
Use Net Enterprise Value Divided by Adjusted EBITA or NOPAT
Why Not Price to Earnings?
Why Not EV to EBIT?
Choosing between EBITA and EBITDA
NOPAT vs. EBITA
Adjust for Nonoperating Items
Use the Right Peer Group
Alternative Multiples
Enterprise Value to Revenues
PEG Ratio
Multiples of Invested Capital
Multiples Based on Operating Metrics
Summary
19. Valuation by Parts
The Mechanics of Valuing by Parts
Building Business Unit Financial Statements
Allocating Corporate Overhead Costs
Dealing with Intercompany Transactions
Understanding Financial Subsidiaries
Navigating Public Information
Cost of Capital
Testing the Value Based on Multiples of Peers
Summary
Part Three. Advanced Valuation Techniques
20. Taxes
Estimating Operating Taxes
Using Public Statements to Estimate Operating Taxes
Converting Operating Taxes to Operating Cash Taxes
Deferred Taxes on the Reorganized Balance Sheet
Finding Deferred Taxes on the Balance Sheet
Valuing Deferred Taxes
Closing Thoughts
21. Nonoperating Items, Provisions, and Reserves
Nonoperating Expenses and One-Time Charges
Separating Operating from Nonoperating Expenses
Searching the Notes for Hidden One-Time Items
Analyzing Each Nonoperating Item for Impact on Future Operations
Provisions and Their Corresponding Reserves
Adjustments for the Provisions
Provisions and Taxes
Closing Thoughts
22. Leases
Accounting for Operating Leases
Valuing a Company with Operating Leases
Reorganizing the Financial Statements
Estimating Free Cash Flow
Incorporating Operating Leases into Financial Projections
Estimating the Cost of Capital
Moving from Enterprise Value to Equity Value
Valuation Using Cash Flow to Equity
Adjusting Historical Financial Statements for Operating Leases
An Alternative Method for Valuing Operating Leases
Closing Thoughts
23. Retirement Obligations
Reorganizing the Financial Statements with Pensions
Reorganizing the Balance Sheet
Reorganizing the Income Statement
Expected Return and Earnings Manipulation
Pensions and the Cost of Capital
Relevering Beta to Estimate the Cost of Equity
Incorporating Pensions into the Value of Equity
Closing Thoughts
24. Measuring Performance in Capital-Light Businesses
Capitalizing Expensed Investments
Example: Capitalizing R&D Expenses
Interpreting Return on Capital, Including Capitalized Expenses
When Businesses Need Little or No Capital
Capital-Light Business Models and ROIC
Economic Profit as a Key Value Metric
Summary
25. Alternative Ways to Measure Return on Capital
When ROIC Equals IRR
When CFROI Equals IRR
Choosing between ROIC and CFROI
Theoretical Trade-Offs
Practical Considerations
Flaws of Other Cash Returns on Capital
Summary
26. Inflation
Inflation Leads to Lower Value Creation
Historical Analysis in Times of High Inflation
Financial Projections in Real and Nominal Terms
Step 1: Forecast Operating Performance in Real Terms
Step 2: Build Financial Statements in Nominal Terms
Step 3: Build Financial Statements in Real Terms
Step 4: Forecast Free Cash Flows in Real and Nominal Terms
Step 5: Estimate DCF Value in Real and Nominal Terms
Summary
27. Cross-Border Valuation
Forecasting Cash Flows
Inflation and Interest Rates
Forward Exchange Rates
Conversion of Cash Flows
Estimating the Cost of Capital
Global CAPM
Applying a Domestic- or Foreign-Capital WACC
Incorporating Foreign-Currency Risk in the Valuation
Using Translated Foreign-Currency Financial Statements
Three Approaches
An Application of the Methods
Summary
Part Four. Managing for Value
28. Corporate Portfolio Strategy
Bet on the Horse—or the Jockey?
What Makes an Owner the Best?
Unique Links with Other Businesses
Distinctive Skills
Better Governance
Better Insight and Foresight
Distinctive Access to Critical Stakeholders
The Best-Owner Life Cycle
Dynamic Portfolio Management
The Myth of Diversification
Smoothing Cash Flow Isn’t the Key
Elusive Benefits, Real Costs
What Does Matter
Conglomerates in Emerging Markets
Constructing the Portfolio
Assessment of Business Units
Scenario Analysis
Summary
29. Strategic Management: Analytics
Adopting a Granular Perspective
Taking the Enterprise View
A Simpler Alternative
Applying Value Drivers to Monitor Performance
Identifying Value Drivers
Understanding Value Drivers Pays Benefits
Creating Actionable Metrics
Setting Targets
Monitoring Results
Summary
30. Strategic Management: Mindsets and Behaviors
Strong Governance
Long-Term Vision
The Right Decision Makers
Granular Decisions
Strong Staff
Debiased Decision Making
Inertia (Stability Bias)
Groupthink
Confirmation Bias and Excessive Optimism
Loss Aversion
Synchronized and Streamlined Processes
Start with Strategy
Build a Plan
Shape Operations
Review Performance, Repeat
Closing Thoughts
31. Mergers and Acquisitions
A Framework for Value Creation
Empirical Results
When Do Acquisitions Take Place?
Do Acquisitions Create Value?
For Whom Do Acquisitions Create Value?
Archetypes for Value-Creating Acquisitions
Improve Target Company’s Performance
Consolidate to Remove Excess Capacity
Accelerate Market Access for Products
Acquire Skills or Technologies Faster or at Lower Cost
Exploit a Business’s Industry-Specific Scalability
Pick Winners Early and Help Develop Their Businesses
Longer-Odds Strategies for Creating Value from Acquisitions
Rolling Up
Consolidate to Improve Competitive Behavior
Enter into a Transformational Merger
Buy Cheap
Estimating Operating Improvements
Estimating Cost and Capital Savings
Estimating Revenue Improvements
Implementation Costs, Requirements, and Timing
How to Pay: With Cash or Stock?
Focus on Value Creation, Not Accounting
Characteristics of Better Acquirers
Engaging in M&A Thematically
Managing Reputation as an Acquirer
Confirming the Strategic Vision
Reassessing Performance Improvement Targets
Closing Thoughts
32. Divestitures
Value Creation from Divestitures
The Costs of Holding On
Why Executives Shy Away from Divestitures
Assessing Potential Value from Divestitures
Lost Synergies
Disentanglement Costs
Stranded Costs
Legal and Regulatory Barriers
Pricing and Liquidity
Deciding on Transaction Type
Private Transactions
Public Transactions
Summary
33. Capital Structure, Dividends, and Share Repurchases
Practical Guidelines
A Four-Step Approach
Step 1: Project and Stress-Test Operating Cash Flows
Step 2: Develop a Capital Structure Target
Step 3: Estimate Surplus or Deficit
Step 4: Decide on a Surplus Payout and Deficit Financing
Setting a Target Capital Structure
Fundamental Debt/Equity Trade-Offs
Evidence on Debt/Equity Trade-Offs
Credit Ratings and Target Capital Structure
Payouts to Shareholders
Dividends
Share Repurchases
Extraordinary Dividends
Equity Financing
Debt Financing
Divestitures of Noncore Businesses
Creating Value from Financial Engineering
Derivative Instruments
Off-Balance-Sheet Financing
Hybrid Financing
Summary
34. Investor Communications
Objectives of Investor Communications
Intrinsic Value vs. Market Value
Which Investors Matter?
Investor Segmentation by Strategy
Targeting Communications by Segment
Communicating with Intrinsic Investors
What Investors Want
Benefits of Transparency
Listening to Investors
Earnings Guidance
No Payoff for Earnings Guidance
An Alternative to Earnings Guidance
Meeting Consensus Earnings Forecasts
When Companies Fall Short
When Companies Meet or Beat the Consensus Forecast
Summary
Part Five. Special Situations
35. Emerging Markets
Why Scenario DCF Is More Accurate than Risk Premiums
Applying the Scenario DCF Approach
Estimating Cost of Capital in Emerging Markets
General Guidelines
Estimating the Cost of Equity
Estimating the After-Tax Cost of Debt
Estimating Capital Structure and WACC
Other Complications in Valuing Emerging-Markets Companies
Triangulating Valuation
Summary
36. High-Growth Companies
A Valuation Process for High-Growth Companies
Start from the Future
Work Backward to Current Performance
Develop Scenarios
Weight Scenarios
Uncertainty Is Here to Stay
Summary
37. Cyclical Companies
Share Price Behavior
An Approach to Valuing Cyclical Companies
Implications for Managing Cyclical Companies
Summary
38. Banks
Economics of Banking
Net Interest Income
Fee and Commission Income
Trading Income
Other Income
Principles of Bank Valuation
Analyzing and Forecasting Equity Cash Flows
Discounting Equity Cash Flows
Pitfalls of Equity DCF Valuation
Economic-Spread Analysis
Economic Spread vs. Net Interest Income
Complications in Bank Valuations
Convergence of Forward Interest Rates
Loan Loss Provisions
Risk-Weighted Assets and Equity Risk Capital
Value Drivers for Different Banking Activities
Summary
39. Flexibility
A Hierarchy of Approaches
Uncertainty, Flexibility, and Value
What Creates Flexibility Value
Managing Flexibility
Methods for Valuing Flexibility
Real-Option Valuation
Valuation Based on Decision Tree Analysis
Comparing ROV and DTA Approaches
Four Steps to Valuing Flexibility
Real-Option Valuation: A Numerical Example
Real-Option Valuation and Decision Tree Analysis: A Numerical Example
DTA Approach: Technological Risk
ROV Approach: Technological and Commercial Risk
Summary
Appendix A. Discounted Economic Profit Equals Discounted Free Cash Flow
Proof Using Perpetuities
Generalized Proof
Appendix B. Derivation of Free Cash Flow, Weighted Average Cost of Capital, and Adjusted Present Value
Enterprise Discounted Cash Flow
Adjusted Present Value
Appendix C. Levering and Unlevering the Cost of Equity
Unlevered Cost of Equity
Unlevered Cost of Equity When ktxa Equals kd
Unlevered Cost of Equity When Debt is Constant
Levered Cost of Equity
Levered Beta
Unlevered Beta and Pensions
Appendix D. Leverage and the Price-to-Earnings Multiple
Step 1: Defining Unlevered P/E
Step 2: Linking Net Income to NOPAT
Step 3: Deriving Levered P/E
Appendix E. Other Capital Structure Issues
Pecking-Order Theory
Market-Based Rating Approach
Leverage, Coverage, and Solvency
Appendix F. Technical Issues in Estimating the Market Risk Premium
Calculate Premium Relative to Long-Term Government Bonds
Use the Longest Period Possible
Use an Arithmetic Average of Longer-Dated (e.g., Ten-Year) Intervals
Appendix G. Global, International, and Local CAPM
Global CAPM
International CAPM
Local CAPM
Appendix H. A Valuation of Costco Wholesale
Modeling the Financial Statements
Reorganizing the Financial Statements
Forecasting the Financials
Estimating Continuing Value
Estimating the Weighted Average Cost of Capital
Valuing the Enterprise and Converting to Equity
Putting the Model to Work
Appendix I. Two-Stage Formula for Continuing Value
Index
EULA