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. 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
31
32. 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
32
35. Creating Value through divestitures
• What evidence is there that divestitures create value,
and what drives that value creation?
• What is an effective approach to deciding on divestitures
transactions?
• How should management choose the specific type of
transaction for a divestiture?
35
36. Divestiture tend to occur in waves
36
1960s and 1970s
1980s
1990s
2000s
The conglomerate excesses
Many companies focused their portfolios.
These divestitures were sales to companies or
private buyout firms
The divestiture wave included more public owner
ship transactions, such as spin-offs, carve- outs,
and tracking stocks.
Public owner ship have become an established
means for divesting business.
38. Value creation from divestitures
• Because divestitures create value for corporations in the
short term around the announcement, as well as over
the longer term following the transaction, executives
should focus on divestitures’ potential for creating value.
38
39. Evidence for value from divestitures
• A study of 370 private and public companies found significant
positive excess returns around the announcement of different types
of divestitures.
• 200 large U.S. companies over a 10 year period showed that
companies with a passive portfolio approach(those did not sell
business or only sold poor businesses under pressure)
underperformed companies with an active portfolio approach.
• The best performers systematically divested as well as acquired
companies.
39
40. Why divestitures create value?
• Divesting a business unit creates value when other owners believe
the unit is worth more under their ownership than the sellers believe
the business worth to themselves.
• Chapter19 introduced “best owner principle”. Business units can be
worth more in another ownership structure because the current
structure may impose costs on the parent and/ or business unit.
• Divestitures also may create value by taking advantage of
information asymmetry.
– Certain executive may recognize early on that upcoming technological changes
or a shift in consumer behavior will change the potential value of particular
activities, so they decide to exit through a divestiture before others start to
recognize these trend.
40
41. Cost to the parents and unit
depressed exit price
41
Cost to the parents
Cost to the units
Depressed exit price
Stable units may remove the impetus to innovate, when
this impetus might be a critical driver of success for
other, small businesses in the portfolio.
All companies evolve through a life cycle, from start-up
through expansion to maturity, and different skills an
capability are needed to manage the business well at
different moments in the cycle.
Companies that hold on to seriously
underperforming business too long risk bringing
down the value of the entire corporation.
42. Why executives shy away from divestitures
• Although an active portfolio approach recognize the value to be
created from divestitures, most executives seem to shy away from
an active approach.
• Almost 60% of the companies had executed two or fewer
divestitures over the 10-year period.
• Many managers dislike divestitures because these transactions
dilute corporate earnings. However, if another party is willing to pay
more for the subsidiary than the value the parent company expects
to extract, the divestiture will create and should be pursued.
42
44. Why executives shy away from divestitures
• It is perhaps not surprising that a change in corporate leadership
seems to be one of the key triggers for divestiture.
• Among the 200 companies researched, about half of their major
divestitures took place in companies when the chief executive officer
was fairly new.
44
45. How to approach divestitures
• Synergies and shared assets, services, or systems
• Financing and fiscal changes
• Legal, contractual, or regulatory barriers
• Pricing and liquidity of the assets
45
46. Deciding on transaction type
46
Forms of
divestiture
Private
transactio
n
Private
transaction
Public
transactio
n
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
47. Spin off
• Full separation maximize the strategic flexibility of the subsidiary, provides
the greatest freedom to improve operations by sourcing from more
competitive companies(instead of the former parent), and avoids conflicts of
interest between the parent company and the business unit.
• Analysis of parent and subsidiary performance of a sample of spin-off
transactions shows that the operating margin of a spun-off subsidiary
improves by one-third on average during the three years after completion of
the transaction.
• The positive performance of the subsidiaries is driven by focus-improving
spin-off. Transactions that did not improve focus had mostly negative post
transaction returns.
47
49. Carve-outs
• Sometimes parent companies don’t want to give up control over a business
unit. The reason could be a desire to maintain some synergies between
parent and subsidiary or to shelter the subsidiary from market forces such
as mergers and acquisitions.
• In our research, the majority of the carve-out entities did not last. Only 8% of
the carve-out subsidiaries remained majority-controlled by the parents.
– The majority of the subsidiaries were spun off further, acquired, or merged with other
players.
• The low market returns could have resulted from the subsidiary lacking the
opportunity to maximize its potential under continued parent control, or the
parent taking advantage of high market valuation levels at the time, without
considering real ongoing benefits of full separation.
49
51. Tracking stock
• Tracking stock offers a parent the advantage of maintaining control
over a separated subsidiary, but it often complicates corporate
governance.
• Tracking stock is used far less often than carve-out and spin-off
transactions, implying that this form of ownership restructuring fails
to bring the benefits executives are looking for.
51
52. Summary
• As business go through their life cycles, they pose new challenges
to the structure of their parent corporation’s portfolio.
• Most corporations divest businesses only after resisting shareholder
pressure. In delaying, they risk forgoing the potentially significant
value they could create by taking an active approach to divestitures.
• Ideally, executives should an ongoing, proactive divestiture program
to evaluate the corporate portfolio continually as its business evolve
through their life cycles and the industry itself changes.
52
53. Variation in growth over product life cycle
53
Sustaining growth is difficult because most product markets have natural life cycles.
Exhibit5.4 (P90)
54. 54
Exhibit 5.9
Unstable Growth for Industries
(P96)
Top 5 industries 1967−1977
1. IT services
2. Software services
3. Broadcasting
4. Computers and peripherals
5. Paper Packaging
Top 5 industries 1997−2007
1. Integrated oil and gas
2. Health-care equipment
3. Energy equipment and services
4. Movies and entertainment
56. 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
56
57. Capital structure
• Careful design and management of a company’s capital structure do
more to prevent value destruction than to boost value creation.
• When managers make decisions about capital structure, they
usually have much more to lose than to gain in terms of value.
• This chapter addresses the following topics in details.
– The impact of capital structure on value creation for shareholders.
– The role of credit ratings in capital structure decisions
– Choosing the short-term steps to manage a capital structure
– Establishing long-term capital structure targets
– Creating value from financial engineeging
57
58. Trade offs in capital structure design
58
Tax savings
Reduction of
corporate over
investment
Costs of business
erosion and
bankruptcy
The most obvious benefit of debt over equity is
reduced taxes.
According to the free cash flow hypothesis, debt
can help impose investment discipline on
managers.
Higher levels of debt give rise to costs from
business erosion.
Cost of investor
conflicts
Higher leverage may cause additional loss of value as a
result of conflicts of interesting among debt holders,
shareholders, and managers, particularly through the
measures that debt holders to take to protect their
interests.
60. Pecking-order theory
• One of the causes of pecking order is that investors interpret
financing decisions by managers as signals of a company’s
prospect.
– Investors will interpret an equity issue as a signal that management belives
shares are overvalued.
• The signaling hypotheses underling the pecking order theory are
more relevant to financial managers in selecting timing specific
funding alternatives than for setting long-term capital structure
targets.
60
Using internal
funds
Issuing debt
Issuing debt
61. Is there an optimal capital structure
• Leverage matters less than we think
– The costs of business erosion and investor conflicts will become significant and
offset some of the tax savings.
– The expected value of any tax savings will itself decline because of the growing
probability that the company will not capture these savings in the first place.
• High leverage levels are unsustainable and more likely to destroy
shareholder value, due to a high probability of business erosion,
investor conflicts, and ultimately bankruptcy.
61
62. Setting an effective capital structure
• Peer group comparison
– By analyzing what capital structure most companies in the peer group
have, you obtain at least some understanding of what a reasonable
capital structure could be.
• Credit rating analysis
• Cash flow analysis
– Each company will face specific challenges arising from its particular investment
needs, dividend policy, and other considerations.
62
63. Credit ratings and capital structure
1. Ratings are useful summary indicator of capital
structure health.
2. Rating largely determine the company’s access to the
debt markets.
3. Credit ratings are nowadays important elements in the
communication to shareholder.
63
65. Drivers of credit ratings:
Coverage and size
• Empirical evidence shows that credit ratings are primarily
related to two financial indicators.
– Size in terms of sales or market capitalization
– Interest coverage in terms of EBITA, EBITDA or debt divided by
interest expense.
65
67. Credit spreads from credit ratings
• From a company’s credit rating, you can estimate the
interest rate payable on its debt funding.
67
68. Leverage and solvency versus coverage
• A leverage ratio measures the company’s ability to cover its interest
payments over a very long term.
• Coverage indicates how easily a company can service its debt in the
near term.
• Colvency becomes more relevant in times of financial distress, when
a company’s creditor use it as a rough measure of the available
collateral.
68
69. Short-term steps to manage capital structure
• Empirical analyses have demonstrated that companies actively
manage their capital structure and stay within certain leverage
boundaries.
• When managing their capital structures, companies need to take
account of the transaction costs and signaling effects associated
with different adjustments.
• For listed companies, capital structure decisions are complicated by
the fact that they send the capital markets signals about a
company’s prospect.
– Signal effects, coming on top of any effect on intrinsic value made by a change in
capital structure , may dampen but could also amplify that effect.
69
70. Raising additional funds
70
Cutting dividends
Issuing equity
Issuing debt
Companies are extremely reluctant to cut dividends to
free up funding for new investments, because the stock
market typically interprets such reductions as a signal of
lower future cash flow.
・Issuing equity is likely to lead to a drop in share prices in the
short term.
・Because investors assume that managers have superior insights
into the company’s true business and financial outlook, they
believe managers issue equity only if a company’s shares are
overvalued in the stock market.
・investors interpret the issuance of new debt much more
positively than equity offering.
・Because companies commit to fixed future interest
payments that can be withheld only at considerable cost,
investors see the issuance of debt as a strong signal that
future cash flows will be sufficient.
71. Redeeming excess funds
71
Dividend increase
Share repurchases
Debt repayment
・Companies increasing their dividends generally receive
positive market reactions of around 2% on the day of
announcement.
・The drawback of increasing dividends is that investors
interpret this action as a long term commitment to higher
payouts.
・Investors typically interpret share repurchases positively
for several reasons.
-indicating to investors that management believes the
company’s shares are undervalued.
-showing that managers are confident future cash flows
are strong enough to support future investment and debt
commitment etc
・Debt repayment does not meet with positive stock
market.
-indicating to investors that management believes stocks
are overvalued.
-signaling future cash flows may not be sufficient to
support current level of debt
-signaling a lack of investment opportunities.
72. Project funding surplus or deficit
• Estimate expected operating and investment cash flows
• Analyze exposure to business risks
– Understand the uncertainty around the cash flow projections. The more cash
flows fluctuate across the business cycle, the more you should aim for a robust
target capital structure.
• Scope potential for unexpected investment opportunities
– A company can substantially outperform its competitors if it develops a
countercyclical strategic capital structure and maintains less debt than might
otherwise be optimal.
• Project as-is financing surplus or deficit
72
73. Creating value from financial engineering
• Financial engineering
– Managing a company’s capital structure for maximum
shareholder value with financial instruments beyond straight debt
and equity
– Such as synthetic leasing , mezzanine finance, securitization,
commodity-linked debt, commodity and currency derivatives, and
balance sheet insurance.
73
74. Three basic tools of financial engineering
• Derivative instruments
– With derivative instruments, such as forwards, swap, and
options, a company can transfer particular risks to third parties
that can carry these risks at a lower cost.
• Off-balance-sheet financing
– Operating leases, synthetic leases, securitization, and project
finance.
• Hybrid financing
– Involving forms of funding that share some elements of both
equity and debt.
74
75. 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
75
76. 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.
76
77. Intrinsic value vs Market value
• Senior executives often claim that the stock market undervalues or
“doesn’t appreciate” their company.
• It should start with an estimate of the size of the gap, if any,
between management’s view of the company’s intrinsic value and
the stock market value.
• In practice, after some thoughtful analysis and probing, we typically
find that no significant gap exists or that any gap can be explained
by the company’s historical performance relative to shareholders’
expectations.
77
78. Understanding the investor base
• Shares of companies that have relatively high book value or earnings
multiples are designated ”growth” stocks by agencies. Shares of companies
outside this group are labeled “value” stocks by the investor community.
• Growth stocks do have higher ROICs than value stocks. The distributions
across revenue growth levels are similar, whereas the distributions across
ROIC levels are markedly different.
78
79. Revenue growth decay analysis
79
Growth decays very quickly;high is not sustainable for the typical company.
Exhibit5.10 (P97)
80. Non financial Companies
:ROIC Decay Analysis
80Companies'rates of ROIC generally remain fairly stable over time.
Exhibit4.8 (P77)
81. Understanding the investor base
• In chapter 18, we introduced an investor classification system based
on differences among investors’ portfolio-building strategies, which
offers a better understanding of which investors drive share prices.
• Companies should focus their investor communications on intrinsic
investors.
81
82. Classification of investors
82
The type of
stock or
indexes
Growth
Value
Investment
strategy
Intrinsic
investors
Traders
Mechanical
investors
83. Classification by investment starategy
83
Intrinsic investors
Traders
・taking positions in companies only after undertaking
rigorous due diligence of their inherent ability to
create long term value.
・holding 20 to 25% of institutional U.S equity.
・seeking profits by betting on short term movements
in share prices, typically based on announcements
about the company or technical factors.
・holding 30 to 35% of institutional U.S equity.
Mechanical investors
・Making decisions based on strict criteria or
rules.
・controlling 35 to 40% of institutional U.S
equity.
84. Communicating to intrinsic investors
• Intrinsic investors are sophisticated: they want transparency about results,
management’s candid assessment of the company’s performance, and
insightful guidance about the company’s targets and strategies.
• Transparency
– Legislation and accounting rules continually require more transparency.
– A company’s competitors, customers, and suppliers already know more about
any business than its managers might expect.
• Guidance
– In the view of many companies’ executives, the ritual of issuing
guidance on their likely earnings per share(EPS) in the next
quarter or year is a necessary, if sometimes onerous, part of
communicating with financial markets.
84
