Fundamental%20Principles%20of

1
Chapter 2
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• Fundamental Principles of
• Measuring and Managing Value

2
Session Overview

• Traditional rules of thumb about valuation can be
  misleading, and in some cases harmful. We start
  our discussion by demonstrating why EBITDA and
  earnings per share (EPS) often fail to measure
  value.
• In the second part of our discussion, we
  demonstrate how the value of a company can be
  traced to four key value drivers core operating
  profit, return on capital, cost of capital, and
  organic revenue growth.
• Value creation and the practice of finance are
  about trade-offs. Although an action can lead to
  an improvement in one metric (such as worker
  productivity), it may have an adverse impact on
  other metrics, such as growth or capital
  required.
• Every business, product category, customer group,
  and channel must be thoroughly evaluated for the
  potential of growth and profitability.

3
Operating Profit and Free Cash Flow

• Company A earns 100 million a year in after-tax
  profit. Part of the profit will be reinvested in
  the business, the remainder distributed to
  investors.

Paid in taxes
80
EBITDA 180
Financial Terms
50
Investment Rate (IR) 50
Reinvested in business
EBIT(1 - T) 100
50
Payout Rate 50
Returned to investors
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Operating Profit and Free Cash Flow

• The company plans to reinvest 50 million at a
  10 percent rate of return.
• This investment leads to an extra 5 million in
  profits.
• For simplicity, we assume all ratios, the
  investment rate, and so on never change.

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Which Company Is Worth More?

• Both Company A and Company B currently generate
  100 million in profit and are expected to grow
  profits by 5 percent.
• If both companies have 100 million shares
  outstanding, what would each companys EPS and
  EPS growth rate be?

6
EPS Growth Only Part of the Story!
Boston Scientific 3rd-quarter loss narrows Bill
Berkrot, Reuters NEW YORK, Oct. 21
(Reuters)Boston Scientific reported a smaller
third-quarter net loss on Tuesday as increased
sales of implantable defibrillators helped to
offset charges and a decline in sales of its
drug-coated stents. The company's adjusted
profit of 18 cents per share topped Wall Street
expectations by 2 cents, according to Reuters
Estimates. Total net sales for the quarter fell
to 1.98 billion from 2.05 billion, but that was
in line with Wall Street expectations. "It was
kind of an on-target quarter and right now with
Boston Scientific, not falling below the range of
expectations is a good thing," said Phillip
Nalbone, an analyst with RBC Capital
Markets. Source Wall Street Journal, October
21, 2009.
BOSTON SCIENTIFIC Stock Price
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The Drivers of Profit Growth

• Before we value the two companies, lets examine
  a general relationship between IR (investment
  rate), ROIC (return on invested capital), and g
  (growth).

Growth Reinvestment Rate of Return
g IR ROIC
Company A 5 50 10 Company B 5
25 20
8
Session Overview

• Traditional rules of thumb about valuation can be
  misleading, and in some cases harmful. We start
  our discussion by demonstrating why EBITDA and
  earnings per share (EPS) often fail to measure
  value.
• In the second part of our discussion, we
  demonstrate how the value of a company can be
  traced to four key value drivers core operating
  profit, return on capital, cost of capital, and
  organic revenue growth.
• Value creation and the practice of finance are
  about trade-offs. Although an action can lead to
  an improvement in one metric (such as worker
  productivity), it may have an adverse impact on
  other metrics, such as growth or capital
  required.
• Every business, product category, customer group,
  and channel must be thoroughly evaluated for the
  potential of growth and profitability.

9
The Growing Perpetuity Formula

• A company is worth the present value of its
  future free cash flows. For example, Company A
  can be valued as

• In our simple example, cash flows grow forever at
  a constant rate. Therefore, we can use the
  growing perpetuity formula to value each company.

via the Growing Perpetuity Formula
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What Drives Value?
But what determines cash flow?
As cash flow rises, what happens to value? As
weighted average cost of capital (WACC) rises,
what happens to value? As growth rises, what
happens to value?
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Deriving the Key Value Driver Formula

• In order to develop the key value driver formula,
  we will rely on two simple substitutions.

Substitution 1 Cash Flow Profit(1 IR)
Substitution 2 Growth IR ROIC
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The Key Value Driver Formula
Terminology Used by Consulting Firms ProfitAfter-
tax operating profit (NOPAT/NOPLAT ) ROICReturn
on invested capital (ROI/RONIC/ROCE/RONA) WACCWei
ghted average cost of capital (hurdle
rate) gLong-term growth in profit and cash flows
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What Drives Value?
As starting profit rises, what happens to
value? As ROIC rises, what happens to value? As
WACC rises, what happens to value? As growth
rises, what happens to value?
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The Growth/Value Matrix

• If the spread between ROIC and WACC is positive,
  new growth creates value.
• The market value of a company with a starting
  profit of 100 million and a 10 percent cost of
  capital is as follows

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How Growth Drives Value

• In 1995, two Fortune 500 companies had 20
  billion in revenue. Since then one company has
  grown dramatically. Which company is the
  high-growth company, A or B?

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The Value of Alternative Strategies

• Assume your company earns a 15 percent return on
  invested capital, while growing at 2 percent. The
  new CEO has argued that the company should grow
  faster, even if it means sacrificing some
  financial performance. What do you think?
• Assume your company earns a 10 percent return on
  invested capital, while growing at 6 percent. The
  new CEO has argued that the company should focus
  on higher-profit customers, even if it means
  reducing growth. What do you think?

17
Creating Value To Review

• As long as the spread between ROIC and WACC is
  positive, new growth creates value. In fact, the
  faster the firm grows, the more value it creates.
  
• If the spread is equal to zero, the firm creates
  no value through growth. The firm is growing by
  taking on projects that have a net present value
  of zero!
• When the spread is negative, the firm destroys
  value by taking on new projects. If a company
  cannot earn the necessary return on a new project
  or acquisition, its market value will drop (and
  often does).