S1 Firm Valuation PDF

Session 1: An Overview of Value Creation Firm valuation reveals the key factors driving a company's success and provides insights into its growth potential and profitability Growth = is how much the company's size, sales, and profits are increasing ov...

Session 1: An Overview of Value Creation Firm valuation reveals the key factors driving a company's success and provides insights into its growth potential and profitability Growth = is how much the company's size, sales, and profits are increasing over time. Return on Capital = how well the company uses its money to make more money. Cost of Capital = is the price a company pays to use money from investors. Companies should take into account the interests of all stakeholders, beyond just shareholders, in their decision making processes. Long-term value creation often requires a consideration of the broader social, environmental, and ethical implications of business activities Despite evidence linking long-term value creation to superior performance, many managers and investors continue to emphasize short-term financial metrics, such as earnings per share (EPS) Earnings per share (EPS) = how much profit a company generates for each outstanding share of its common stock Short-term focus may lead companies to make decisions that prioritize immediate financial gains over sustainable growth and value creation. Cutting essential investments, such as research and development (R&D) and marketing, to meet short-term targets can harm long- term prospects. EPS as a performance measure does not necessarily reflect the true value created by a company. Share price and EPS do not always align with intrinsic value. Session 1: An Overview of Value Creation 1  The objective of firm valuation is to ascertain the fair value of the company's assets, operations, and future cash flows, which can be useful for various purposes, such as: Investment Decision Making Mergers and Acquisitions Financial Reporting Fundraising and Capital Allocation Litigation and Dispute Resolution A Good Company and a Good Investment May Not Be the Same! Real Market: = after-tax operating profit divided by invested = The rate or magnitude of increase in a capital (working capital plus fixed assets). company's revenue, earnings, or market share It is calculated from a company’s financial over a specific period. statements It is a fundamental indicator of a company's expansion and performance, reflecting its ability to increase its size, operations, and market presence. ⇒ Companies create value when they earn a return on invested capital (ROIC) greater than their opportunity cost of capital. If the ROIC is at or below the cost of capital, growth may not create value. Financial Market: The focus shifts from solely creating value through operational decisions to managing investor perceptions and expectations. Goal: actual performance = ou > investors anticipation ⇒ impact share price Intrinsic Value = Intrinsic value is based on future expected cash flows or earnings Share Price = is influenced by investors' expectations of future performance relative to the company's performance Session 1: An Overview of Value Creation 2  Alchemy of Stock Market Performance: A commonly used measure for evaluating the performance of a company and its management is total shareholder returns (TSR) TSR = Percent Change in Market Value + Dividend Yield TSR is heavily influenced by changes in investors’ expectations → good for long period but doesn’t reflect the actual company’s performance Example Explanation: Investors in J&J Snack Foods had very high expectations relative to investors in Tyson Foods (as illustrated by multiples–more about this later) 💬 Expectation Treadmill = A dynamic where high expectations lead to ongoing pressure for exceptional performance ⇒ Companies with low expectations may outperform stock market due to easier target to surpass o The Decision Rule in the Real Market: Choose strategies or make operational decisions that maximize the present value of future cash flow (relative to the investments made) or future economic profit. o The Decision Rule in the Financial Market: Align strategies and actions to meet or exceed the market's expectations of the company's future performance, as reflected in the share price, while simultaneously maximizing the intrinsic value of the company. Session 1: An Overview of Value Creation 3  ESG: ESG (Environmental, Social, and Governance) = the three main factors that are used to evaluate the sustainability and societal impact of a company's operations and management: Environmental: Assessing the impact on the environment e.g. carbon footprint, energy consumption, waste management, and resource efficiency. Social: company's relationships with its employees, customers, suppliers, and communities. e.g. labor practices, human rights, diversity, and community engagement. Governance: company's internal controls, board structure, executive compensation, and shareholder rights to ensure ethical and responsible decision-making. Digital initiatives = the strategic use of digital technology and tools within an organization to improve efficiency, customer experience, and business performance. e.g. digital marketing, automation, data analytics, artificial intelligence, Internet of Things (IoT), and other technological innovations. ESG initiatives may link to cash flow in five Digital initiatives may improve a company’s important ways: performance in five key areas: Facilitating revenue growth New business models Reducing costs Cost reduction Minimizing regulatory and legal interventions Improved customer experience Increasing employee productivity New revenue sources Optimizing investment and capital expenditures Better decision making Approaches to valuation: Session 1: An Overview of Value Creation 4  Equity vs. Enterprise Value: o Equity value: Value of equity stake that reflects the value of claims of equityholders o Enterprise (firm) value: Value of the entire business that reflects the value of all claims on the firm (equityholders, bondholders, preferred stockholders) Mechanics of Valuation: Operating Profit and Free Cash Flow (FCF): Operating profit represents revenues netted of operating expenses Free cash flow to the firm (FCFF) is the cash flow available to all providers of capital after all operating expenses (including taxes) have been paid and necessary investments in working capital and fixed capital have been made 𝑡 = Marginal tax rate EBIT(1-t) is also called NOPAT (net operating profit after taxes) NCC stands for non-cash charges (most important are Depreciation & Amortization) 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 = investment in fixed assets (and acqusitions) ∆ 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = Change in net working capital Session 1: An Overview of Value Creation 5  Investment rate (IR)= Investment/ NOPAT ROIC = NOPAT/Invested Capita = Differences in ROIC–defined as the incremental NOPAT earned each year relative to the prior year’s investment–are what drives difference in values Important example Company A and B has the same earning of $100 million in year 1 and are expected to increase its revenues and earnings at 5% per year. Company A plans to reinvest $50 million at a Company B invests only 25% of its after-tax 10% rate of return earnings. If the popular view that value depends only on earnings were true, the two companies’ values would be the same. But is this the case here? Almost all companies need to invest in plant, equipment, or working capital to grow. Free cash flow (FCF) is what’s left over for investors once investments have been subtracted from earnings. Here, earnings are expressed as Net Operating Profit after Taxes (NOPAT), a term we use throughout the course! Discounted Future Free Cash Flows/Value We can value the two companies by “discounting” their future free cash flows (FCF) at a discount rate that reflects what investors expect to earn from investing in the companies— that is, their cost of capital. (here we’ll assume 10%) Session 1: An Overview of Value Creation 6  Price-to-Earnings (P/E) The companies’ values can also be expressed as price-to-earnings ratios (P/Es); Divide each company’s value by its first-year earnings of $100 million: Company A’s P/E = 1000/100 = 10 Company B’s P/E = 1500/100 = 15 ⇒ Company B generates higher cash flows because it doesn’t have to invest as much as Company A does. Company A needs a higher investment rate to achieve the same growth as Company B Mechanics of Valuation: The Growing Perpetuity Formula: → A company is worth the present value of its future free cash flows (FCF). When companies grows forever at a constant rate: use the growing perpetuity formula… …where WACC (Weighted Average Cost of Capital) is the discount rate used to discount future cash flows This Formula implies high cash flow and high growth are good. However,… Companies can drive high cash flow by eliminating reinvestment. Companies can drive high earnings growth through bad investment. e.g. a negative NPV project that can increase earnings but does not add to value Key Value Driver Formula: Formula explanation Session 1: An Overview of Value Creation 7  As long as the spread Spread is equal to zero: Spread is negative: the firm destroys between ROIC and WACC is the firm creates no value value by taking on new projects. If a positive, new growth through growth. The firm company cannot earn the necessary creates value. In fact, the is growing by taking on return on a new project or acquisition, its faster the firm grows, the projects that have a net market value will drop (and often does) more value it creates. present value of zero! Fundamental Principles of Value Creation: SUMMARY Session 1: An Overview of Value Creation 8  Why is ROIC Important: The Role of ROIC: ROIC (Return on Invested Capital) measures the efficiency of capital utilization. It evaluates how effectively a company generates returns from the capital invested. Reflects the dimension of increasing returns to scale exhibited by each business model. ⇒ The efficient use of capital will improve short-term ROICs, but to maintain long-term ROICs above the cost of capital, the company also needs a sustainable competitive advantage. Session 1: An Overview of Value Creation 9  A higher ROIC results from either a price premium relative to peers, a better cost structure or less capital required per unit (or both). Explanations Price premium (higher cost) = company needs to distinguish them from competitors'. Let's explore five potential sources of price premiums: Unique Products Real (or Perceived) Quality Brand Customer Lock-In = high switching cost Price Discipline / price agreements Cost efficiency = the ability to sell products and services at a lower cost than the competition. Capital efficiency = selling more products per dollar of invested capital than competitors. Let's explore four potential sources of these advantages: Innovative Business Method Unique Resources Economies of Scale Scalable Product/Process ⇒ The longer a company can maintain a high ROIC, the more value it can generate. Sustaining a specific level of ROIC depends, among others, on the duration of its business and product life cycles, the longevity of its competitive advantages, and its ability to renew and adapt its business strategies and product offerings over time. An Empirical Analysis of ROIC Session 1: An Overview of Value Creation 10  Growth and Its Importance in Firm Valuation: 💬 Growth = The pursuit of expansion in a company's revenues, customer base, market share, or acquisitions. It is a critical factor in a company's survival and success. Growth can be Organic (bring higher value): Portfolio Momentum = result from market expansion in existing market segments. Companies innovate and introduce new products/services to attract more customers. Market Share Performance = achieved by gaining or losing market share in a specific market. Companies compete to capture a larger share of the market's revenue. External: Mergers and Acquisitions (M&A) = obtained through acquiring or divesting businesses. Companies strategically acquire or merge with other firms to expand. Sustaining high growth is harder than sustaining ROIC, especially for larger companies. This is mainly due to due to product natural life cycles. Session 1: An Overview of Value Creation 11  Consistently achieving high growth requires entering new markets in their profitable growth phases.Growth targets should be realistic; overly optimistic targets may not be achievable Portfolio Treadmill Effect = for each product that matures and declines in revenues, the company needs to find a similar-size replacement product to stay level in revenues—and even more to continue growing. Effective Growth Strategies: Product Innovation: New categories, minimal competition. Customer Attraction: Expand customer base, benefit competitors. Acquisitions: Bolt-on acquisitions add value with lower complexity. Caution with Market Share Growth: May lead to retaliation. Session 1: An Overview of Value Creation 12