interest, dividends, and potential repayment of debt or even repurchase of its ownshares.After discounting the pattern of annual cash flows over the chosen timeframe at the appropriate r
Trang 1384 Financial Analysis: Tools and Techniques
The added difficulty of forecasting operations beyond the end of the chosenanalysis period suggests that we also find an acceptable shortcut answer for theongoing value A common way of dealing with the problem is to use a price toearnings multiple that might be warranted at that point, i.e., to set the value of thebusiness at the termination point based on 10, 15, or 20 times the after-tax earn-ings in that year The multiple chosen will depend on the nature of the businessand the trends in the industry it represents Because of the power of discounting,such an approximation of the ongoing value will generally suffice at least for aninitial valuation result At times the ongoing value is simply represented by theestimated book value of the business, although this is probably a less satisfac-tory shortcut than the earnings multiple for the reasons we discussed in earlierchapters
Once all the cash flow elements have been estimated, they can be assembled
in the form of a spreadsheet as shown in the generalized format of Figure 11–5,which parallels the various examples we gave in Chapter 8 The resulting annualnet cash flows (free cash flow) represent the cash available to the company tosupport its obligations to all providers of the long-term funds, i.e., the payment of
F I G U R E 11–5
Total Company Valuation—A Numerical Example*
Present Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
EBIT (1 t) $10,000 $12,000 $13,000 $12,000 $13,500 $ 12,500 Add: write-offs and
noncash items 6,500 7,000 8,600 9,300 9,900 11,900 Less: net new working
capital 1,200 1,400 1,800 500 1,600 2,000 Less: net new capital
investments 8,000 15,000 10,200 11,000 22,000 10,000 Add/less: significant
nonoperating items 500 300 400 1,200 800 0 Free cash flow 7,800 2,300 10,000 12,000 1,000 12,400 Ongoing value @ 15 times
earnings — — — — — 187,500 Present value factors
@ 12% 0.893 0.797 0.712 0.636 0.567 0.507
Present values @ cost
of capital 6,965 1,833 7,120 7,632 567 101,349 Cumulative present values $ 6,965 $ 8,799 $15,919 $23,551 $22,984 $124,333 Firm value $124.3 million
Nonoperating assets (cash,
marketable securities, etc.) 5.7 million
Total value $130.0 million
Value of outstanding
long-term debt 40.0 million
Value of shareholders’ equity $ 90.0 million
Trang 2interest, dividends, and potential repayment of debt or even repurchase of its ownshares.
After discounting the pattern of annual cash flows over the chosen timeframe at the appropriate return standard, normally the weighted average cost ofcapital, the resulting net present value should be a reasonable approximation
of the value of the total business Note that the nonoperating assets were added tothe operational firm value to arrive at the total value In our example we’ve shown
an assumed value of $5.7 million, which raises the total value to $130.0 million.The quality of the result depends, of course, on the quality of the estimates thatwere used in deriving it The analyst should employ extensive sensitivity analysis
to test the likely range of outcomes, testing different discount rates and especiallydifferent estimates of the ongoing value In this example the ongoing value based
on the no-growth assumption would be $100 million, when we use a free cashflow estimate of $12 million, divided by the cost of capital of 12 percent With afive percent perpetual growth assumption, the ongoing value would be $12 mil-lion divided by a net factor of 7 percent, or $171 million While the impact of dis-counting moderates the significance of the ongoing value somewhat (the discountfactor in Year 6 at 12 percent is 0.507), the discounted difference between theearnings multiple assumption of $187.5 million we used, and the no-growth freecash flow result of $100 million is still a highly significant $44 million ($87.5
0.507), or about one-third of the final result It’s not unusual to find such sizableranges of outcomes in what amounts to a quantification of future expectations, nothistorical data
It’ll be useful to demonstrate visually how the firm value developed by thispresent value analysis relates to the company’s capital structure What we’vedeveloped by discounting the net cash flow stream and the assumed ongoingvalue, plus nonoperating assets, is the approximate fair market value of the com-pany’s overall capitalization Figure 11–6 demonstrates that the total recordedvalue of a business is the sum of its working capital, fixed assets, and other assets,which are financed by the combination of long-term debt and equity The presentvalue approach has enabled us to express this accounting value in current eco-nomic terms—a present value which might be higher or lower than the recordedvalues on the balance sheet, and which also depends, of course, on all the assump-tions implicit in the cash flow forecasts including the ongoing value Only bycoincidence will the two values be precisely equal, because as we discussed
in Chapter 2, recorded values on the balance sheet reflect historical transactionvalues which tend to become obsolete with the passage of time
It should be evident that to arrive at the market value of the shareholders’equity, we must subtract the value of the long-term debt from the adjusted presentvalue result—which is the market value of the total business, also called value
of the firm or enterprise value In our example, therefore, the value of the holders’ equity is $90.0 million It might be necessary to restate the value of long-term debt based on the current yields prevailing for debt of similar risk, as wediscussed earlier in this chapter, rather than the recorded values on the balancesheet For example, if current interest rates are higher than the stated rates for thecompany’s debt, the value of the debt will be lower than recorded, and vice versa
Trang 3share-386 Financial Analysis: Tools and Techniques
By observing this principle, we remain consistent with the weighted average cost
of capital yardstick that was applied in discounting the cash flow pattern, a sure which contains the cost of incremental debt, as we recall from Chapter 9
mea-A similar deduction must be made for any preferred stock contained in the capitalstructure
We’ve now achieved a direct valuation of the company’s common equity bymeans of an economic (cash flow) approach which is conceptually superior to thesimpler devices discussed in the common stock section of this chapter, althoughsubject to the range of assumptions underlying it This approach is the basis formuch of the analytical work underlying modern security analysis, where the use
of cash flow analysis has begun to overshadow most other methodologies
In a multibusiness company, the approach can be refined by developingoperating cash flow patterns for each of the business units, and discounting theseindividual patterns at the corporate cost of capital If the businesses differ widely
in their risk/reward conditions, one can apply different discount standards thatreflect these differences, as discussed in Chapter 8 In recent years, testing the pre-sent value of individual business units’ cash flow patterns to determine the rela-tive contribution to the total value of the corporation has become widely accepted.Yet, given the nature of the estimates underlying the analysis, there’s noth-ing automatic about the use of such values in an actual transaction involvingthe sale of a company or any of its parts Different analysts and certainly buyersand sellers will use their own sets of assumptions in developing their respective
F I G U R E 11–6Present Value of Business Cash Flows and the Capital Structure
Assets Liabilities
Company book value
Current assets Currentliabilities
term debt
Long-Working capital
Fixed assets
Other assets
holders’
Share-equity
> = <
Present value
of company capitalization
Annual free cash flows
Ongoing value
Market value
Time Represents the basic trade-off of future cash flows for current value…
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Trang 4results There should also be efforts to test the analytical results against rable transactions, to the extent these are available and relevant.
compa-The actual value finally agreed upon in any transaction between a buyer and
a seller will depend on many more factors, not the least of which are the ences in assessing business risk and in the return expectations of the parties in-volved, as well as the in the negotiating stance and skills used by them We’llreturn to the subject of valuation of a company or combination of companieswithin the context of shareholder value creation in Chapter 12
differ-Using Shortcuts in Valuing an Ongoing Business
In the previous example, an earnings multiple based on EBIT was used to derivethe ongoing value of the business This multiple simply indicated what a par-ticular level of current or projected earnings was “worth” at the termination point
of the analysis After-tax earnings or after-tax operating profit are often used aswell Closely related to the price/earnings ratio, this rule of thumb is often applied
to quickly value a company, and the result can be an “opener” in initial tiations Never precise, the earnings multiple is derived from rough statisticalcomparisons of similar transactions, and from a comparative evaluation of theperformance of the price/earnings ratios of companies in the industry Other mul-tiples encountered at times, especially with smaller companies or new businesses,include multiples of sales, or even derived sales volumes based on an estimatedcustomer group
nego-When an actual earnings multiple is turned into a ratio of estimated earnings
to value, it provides a rough estimate of the rate of return on the purchase or ing price—assuming that the earnings chosen are representative of what the futurewill bring When taken as only one of the indicators of value within a whole array
sell-of negotiating data, the earnings multiple and the related crude rate sell-of return havesome merit
Other shortcuts in valuing an ongoing business involve determining thetotal market value of common and preferred equity from market quotations—initself somewhat of a challenge in view of stock market fluctuations—and adjust-ing this total for any long-term debt to be assumed in the transaction One issueinvolved in this approach is the question of how representative the market quo-tations are depending on the trading pattern and volume of the particular stock
At times, when no publicly traded securities are involved, the book value of thebusiness is examined as an indicator of value Needless to say, the fact thatrecorded values don’t necessarily reflect economic values can be a significantproblem
All of these results can at one time or another enter into the deliberations,but considerable judgment must be exercised to determine their relevance in theparticular case In most situations, the discounted cash flow approach will be theconceptually most convincing measure, despite the difficulties of estimatingthe cash flow pattern in specific terms
Trang 5388 Financial Analysis: Tools and Techniques
Key Issues
The following is a recap of the key issues raised directly or indirectly in this ter They are enumerated here to help the reader keep the techniques discussedwithin the perspective of financial theory and business practice
chap-1. The concept of value is not independent of the purpose for which it isused, and its definition and meaning can vary widely with respect tothe conditions and circumstances to which it is applied
2. The value of a security is a function of the expectations about futureperformance placed upon it, which can be individual judgments aswell as collective judgments representing a market
3. Investors approach the valuation of an investment proposition interms of their individual risk preferences and thus will differ widely
in assessing the attractiveness of an investment
4. While the securities markets provide momentary indications, therelative value of a share of common stock in the market at any time is acombination of future expectations, residual claims, and assessments ofgeneral and specific risk, subject to economic and business conditionsand the decisions of management and the board of directors It’s alsoaffected by the breadth of trading in the security
5. Valuation techniques are essentially assessment tools that attempt toquantify available objective data and estimates Yet such quantificationwill always remain in part subjective, and in part impacted by forcesbeyond the individual parties’ control
6. Valuation of a security or a business is distorted by the same elementsthat distort other types of financial analysis: price-level changes,accounting conventions, economic conditions, market fluctuations,and many subjective intangible factors
7. Validation of results achieved from valuation projects ultimately has toawait actual performance in the future; this is why the importance ofsound judgments at the time of the analysis cannot be overstated
Summary
In this chapter, we’ve brought together a whole range of concepts and basic niques to provide the reader with an overview of how to value assets, securities,and business operations To set the stage, we discussed key definitions of value,and then took the viewpoint of the investor assessing the value of the three mainforms of securities issued by a company After covering both value and yield inthese situations, we expanded our view to encompass the valuation of an ongoingbusiness Our purpose was to find basic ways of setting the value in transactionssuch as sale of a business, restructuring, or the combination of companies in theform of a merger or acquisition
Trang 6tech-We found that methods were available for deriving such values, but that thespecific assumptions and the background of the transaction added many, oftencomplex, dimensions to the basic calculations We demonstrated the valuation of
a business specifically in cash flow terms, and showed how a company’s equitycan be valued based on cash flow expectations, quite similar to the business in-vestment analysis we discussed in Chapter 8 Ultimately, value will always remainpartially subjective and will be settled in an exchange between interested par-ties—but managing effectively for economic performance and value will alwaysremain the basic obligation of management
Analytical Support
Financial Genome, the commercially available financial analysis and planning
software described in Appendix I, has the capability to develop and display grated financial projections directly from input data and built-in data bases, usingthe application’s forecasting capabilities It can automatically derive accountingmeasures as well as common cash flow inputs to valuation analysis The software
inte-is also accompanied by an interactive template (TFA Template under “extras”) forthe cash flow valuation of a business, based on Figure 11–5 on page 384, whichcan be used to calculate present values and the equity valuation for any pattern ofinputs and discount rates The historical database on TRW Inc contained in thesoftware can be used to develop projected statements and free cash flow as an in-put to the valuation template (see “Downloads Available” on p 431)
Ridge, IL: Irwin/McGraw-Hill, 1999.
Weston, Fred; Scott Besley; and Eugene Brigham Essentials of Managerial Finance 11th
ed Hinsdale, IL: Dryden Press, 1996.
Trang 7This page intentionally left blank.
Trang 8MANAGING FOR SHAREHOLDER VALUE
We now return to the primary concept we established at the beginning of thisbook, namely, that the basic obligation of the management of any company is tomake investment, operating, and financing decisions that will enhance share-holder value over the long term Our discussion of valuing business cash flows inChapter 11 strongly suggested that management should periodically reexaminethe company’s policies and strategies to test whether its basic obligation of creat-ing shareholder value is in fact being met We recall that increasing shareholdervalue depends on making new investments that exceed the cost of capital—an ex-pression of investor expectations—as well as managing all existing investmentsfor cash flow results that similarly exceed investor expectations
The most beneficial aspect of the growing emphasis on shareholder valuecreation over the past decade has been the widespread rediscovery of managementfundamentals—even if at times under threat of dismissal by hostile raiders De-spite the periodic lapses of economic discipline exemplified in the recent dot.combubble, which we discussed in Chapter 1, there has been real progress made withthe prospect of more to come Growing numbers of corporate managers, in theU.S and in other parts of the world, are tackling the critical task of creating valuefor their shareholders They are doing this by reexamining the structure and func-tioning of their company as a whole and by placing greater emphasis on makingtheir decisions, large and small, on the basis of sound economic trade-offs Thebasic imperative of requiring all investments to earn above the cost of capital hasbeen rediscovered as a practical—even if difficult to achieve—goal Vast efforts
at restructuring, increasing cost-effectiveness, making disinvestments and sitions, and developing value-based processes, data flows, measures, and incen-tives are being carried out in the name of shareholder value creation In fact,testing the efficiency with which all resources are employed and defining therelative contribution from various business segments with an objective “outside”orientation has become commonplace in many companies One could argue that
acqui-391
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Trang 9392 Financial Analysis: Tools and Techniques
this approach should really have been commonplace all along, because of thelong-established fact that all business decisions have an economic basis—whetherthis is recognized or not A number of specialized measures and valuation method-ologies have emerged in support of value-based management principles, whichwe’ll discuss later in this chapter
Shareholder Value Creation in Perspective
Before we turn to a detailed discussion of value-based measurement techniques,it’ll be useful to revisit the business system as shown in Figure 12–1 to provide
an overall perspective for the various analytical processes presented in this book,and to review their relationship to shareholder value creation Two additional
F I G U R E 12–1
Shareholder Value Creation in a Business System Context
investment Depreciation
Dis-effect
Interest (tax-adjusted) Dividends
paid
New investment
Leverage
Volume Price
Costs (fixed &
variable)
Investment base
Shareholders'
equity
Long-term debt
Operating profit after taxes
Earnings retained
in company
Funds available for growth
Managing all new business investments
as well as all existing investments for a targeted economic return above the cost
of capital Managing all operations for competitive advantage and cost-effectiveness
Managing the trade-off between dividends, debt service, and reinvestment
Managing the capital structure for proper leverage, acceptable risk, and future flexibility
Funding of company growth, given attractive opportunities suitable for the portfolio
Exceed cost of capital Meet return goals
Meet key success measures
Cost/benefit analysis
Risk/reward analysis
Opportunity analysis
Trang 10overview perspectives in Figures 12–2 and 12–3 also will help set the stage forthis chapter.
As the upper part of the diagram shows, companies focusing on holder value will tailor their analytical processes and physical implementation
share-to achieve economic (cash flow) returns above the cost of capital on new vestments as well as on existing investments, making sure that return goals areset at appropriate levels and in the proper economic context We recall the dis-cussion of Chapters 7, 8, and 9 in which the principles and the measures sup-porting this approach were presented One of the key issues to be faced in thisarea, however, is the dichotomy between the economic analysis of new invest-ments, where expected cash flow patterns can be judged in an incremental fash-ion, and the analysis of the existing investment base, where normal accountingdata and recorded values are the main source of information It is here wheremuch of the development of value-based methodologies has taken place, in aneffort to close the conceptual gap between cash flow economics and ratio-basedconventional analysis
in-The midsection of the diagram reflects our familiar set of operational offs, which in a value creation context, should be made with long-term cash flowgeneration in mind Excellent product and service offerings, competitive advan-tage, and cost-effectiveness are the underlying driving forces, but the many deci-sions supporting daily activities require not only an analytical understanding oftheir cash flow impact, but also measures and incentives that reinforce economicdecision making Again, the increasing emphasis on value-based management isfueling a shift away from accounting-based methodology toward cash flow frame-works We encountered some of this trend in our discussion of the analyticalapproaches of earlier chapters, and we’ll expand on the measures and their impli-cations later in this chapter
trade-The bottom part of the diagram deals with the financing aspects of valuecreation, where we recognize the many trade-offs we’ve encountered in Chap-ters 6, 9, and 10 Companies with a value orientation consciously manage thesetrade-offs for long-term cash flow generation, and view the disposition of profitsand the target dimensions of the capital structure as critical supportive elements intheir strategic planning Choices that affect dividend payout, changes in leverage,repurchase of shares, and funding of future opportunities are made against thecriterion of value creation The trade-offs chosen here can at times significantlyaffect the direction of the company’s strategy
Another overview of the integration of financial, strategic, and operationalactivities supporting shareholder value creation is provided in Figure 12–2 Here
we see the core concept of earning in excess of the cost of capital surrounded bythe key management activities, starting at the top with the evaluation and selection
of sound strategies, leading to broad resource allocation and the analysis of cific business investments In this area the analytical tools of Chapters 7 and 8come into play This is followed by the identification of those elements and vari-ables that drive value creation, which form the basis for operational targets and the
Trang 11spe-394 Financial Analysis: Tools and Techniques
measures by which performance is gauged Here the materials of Chapters 3, 4,and 5 have relevance Next is the critical area of designing incentives for man-agers to act in an economic fashion, and to support a long-term view of decisionmaking We’ve not focused on such incentive programs because they are beyondthe scope of this book However, financial and other measures selected for thepurpose must reinforce the economic (cash flow) orientation we have stressedthroughout
Finally, there’s the broad strategic issue of the portfolio of activities carried
on by the company, which is intimately connected with the capital structureproportions and trade-offs Here the materials in Chapters 6, 9, 10, and 11 are theappropriate background
Let’s now turn to a final summary overview of the major elements of holder value creation and their relationship to the three areas of managementdecisions: investments, operations, and financing The diagram in Figure 12–3will be useful in tying together the various concepts we’ve discussed It’s de-signed to assist the reader in visualizing the linkage between management deci-sions and shareholder value The diagram shows the three basic types of decisions
share-on the left and identifies their key impacts share-on the cash flows that are the driversfor creating value The combination of investment and operating decisions gener-ates cash flow from operations after taxes, or free cash flow, while the financingdecisions influence the capital structure and the level of the weighted cost of cap-ital of the company Applying the cost of capital—which of course reflects ex-pected investor returns—as a discount rate to the free cash flow and ongoingvalue determines the total shareholder value, as discussed in Chapter 11 At thesame time, product life cycles, competition, and many other influences affect the
F I G U R E 12–2
Shareholder Value Creation in a Management Context
1 Achieve cash returns above the cost of capital
2 Make sound new investments
Seek and evaluate sound strategies Allocate resources
to strategies selected
Define and set operating targets and implementations Evaluate results
consistently with appropriate measures
Identify and evaluate specific new investments within strategic context
Identify and test key value drivers
Manage capital structure proportions
Achieve economic behavior
with relevant incentives
Trang 12size and variability of these projected cash flows In turn, the capital markets fluence the investor’s return expectation.
in-Alternatively, the right side of the diagram shows that shareholder valuealso can be viewed in the form of total shareholder return (TSR), which we know
to be the combination of cash dividends and realized capital gains, when seenthrough the eyes of the shareholder This investor viewpoint is inseparable fromthe basic driving force of the business—cash flow patterns—for it is positive freecash flow that will permit the company to pay dividends in the first place, and alsowill boost the market value of the shares, enabling the investor to realize capitalgains Naturally, it’s possible to create value by minimizing dividends and rein-vesting all funds in soundly based opportunities The value increase would thencome from capital appreciation, assuming successful implementation and ex-pected growth in cash flow performance Conversely, under conditions wheresound new opportunities are not available, it might be best for the shareholdersthat the company repurchase shares rather than invest in mediocre business pro-jects to avoid destroying value
What are the implications of the three overviews we’ve just presented? Notethat we’ve once more returned to a systems view of the corporation, driven by thesame three basic management decisions, but stressing even more the cash flow pat-terns that are the economic underpinning of performance and value All financialanalysis techniques and methodologies discussed in this book are ultimately related
to the business system and its strategic context as viewed here and in Chapter 2,
F I G U R E 12–3
Shareholder Value Creation in a Cash Flow Context
Operatingdecisions
The manager
gains
holdervalue
Share-Free cash flow from activities;
ongoing value
Financingdecisions
Investmentdecisions
Expectations
Capital markets
Competition;
life cycles;
economic environment
Price/volume/
cost offs;
trade-cost ness
effective-Debt;
equity;
leverage;
payout repurchase
Working capital;
facilities;
programs
Discount rate
Cost of capital
The investor
Trang 13396 Financial Analysis: Tools and Techniques
and it’s important that the analytical use of any measure, or a combination of sures, be judged in this sense
mea-The basic message of managing for shareholder value is nothing more thanmanagement’s obligation to base all of its investment, operating, and financingdecisions on an economic—cash flow—rationale, and to manage all resources en-trusted to its care for superior economic returns Over time, consistency in this ap-proach will generate growing shareholder value, and relative growth in share priceperformance If this sounds fundamental, it’s intended to be, since the challengefor the 21st century is competitive survival through managing better in a worldarena—where economic fundamentals are gaining dominance over ideology.Financial analysis in its many forms, as introduced in Chapter 2 and specificallyexplained in the remainder of this book, is an essential toolkit for analytically ori-ented persons of any viewpoint, as they judge the financial/economic performanceand outlook of any business
Evolution of Value-Based Methodologies
Over the last two decades, a number of value-based methodologies have evolvedand are gaining increasing acceptance Their basic aim is to link performance ex-pressed in past and expected cash flow patterns or their surrogates to the marketvalue of a company as a whole and to the relative price level of its commonshares They have become popular within the context of value-based management
processes, and various consulting firms use these approaches to establish a firm
connection between management actions and shareholder value results over, such programs relate cash flow thinking and results to management in-centive pay They are designed to provide a coherent set of economic principlesthat should guide a company’s planning processes, investment policies, financingchoices, operational decisions, and management incentives toward increasingshareholder value, as displayed earlier in our overviews
More-The change in thinking underlying these processes is exemplified in thesimple diagram of Figure 12–4, which displays the significant shift in emphasis asreflected in the way corporate performance is being measured
Prior to the 1980s, management emphasis in the majority of situationstended to be on achieving consistently high profit margins The asset base neces-sary to support operations was of secondary importance, almost an afterthought,
as indicated by the separation border The idea was that if margins were highenough, asset recovery and returns would take care of themselves, as would fund-ing of new investment needs for rapid growth Needless to say, companies apply-ing this way of thinking did not make the best use of invested funds, and asseteffectiveness was problematic In the ’80s the emphasis shifted toward growth ofprofits in absolute terms, again with a focus on the operating statement and less at-tention paid to asset effectiveness With some luck, sufficient profit growth wouldsupport existing and new investments, but this mindset still left asset effectivenessopen to real questions
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Trang 14It wasn’t until the ’90s that formal closure began between the asset base andoperating profits, usually in the form of a percent return of profits on assets, ex-pressed in a variety of ways While recorded values and accounting-based profitcould introduce distortions, and while using short-term returns as a goal couldlead to less than optimal new investment actions, combining assets and profitabil-ity was a significant step toward a more integrated way of judging results andmaking new decisions As more economic and integrated measures began to
be used in practice, growing efforts were made to deal with the shortcomings ofaccounting-based thinking, and to provide more meaningful signals to managers
at all levels Shareholder value creation was introduced and was based on a ety of adjusted data representing the asset base and operating results
vari-One key element was the rediscovery of the cost of capital (which first peared in economic literature around 1890!) as a key criterion for judging per-formance The concept of economic profit was defined as the excess of adjustedearnings over the cost of the adjusted resources supporting them Another key ele-ment was the rediscovery of cash flow as the driver of value, whether in the form
ap-of free cash flow for judging a whole company, or net cash flows for investmentproposals Various cash flow measures gained importance, among them cash flowreturn on investment (CFROI) in a variety of forms The common theme duringthis evolution was the belated recognition that any business entity is in fact aneconomic system which has to be judged over a reasonable time horizon with
F I G U R E 12–4
The Changing Emphasis in Corporate Performance Measures
"History" The 80s The 90s Emerging Practice
"Profit Margin"
¥ High growth
environment
¥ Any growth environment
¥ Any growth environment
¥ Valuation and strategy tools
*EVA is a registered trademark of Stern Stewart & Co.
¥ Lower and inconsistent growth conditions;
Asset
base
Asset base
Asset
Cost of capital
ments
Sales
Costs
Current asset values
Cash flow
% CFROI
Trang 15398 Financial Analysis: Tools and Techniques
performance and value criteria that reflect and encourage the cash flow trade-offsunderlying management decisions, incentives, execution, and results
A Review of Key Measures
At this point we should review in broad terms the key performance and valuemeasures encountered in current business practice, and to comment in more detail
on several of the emerging tools that support shareholder value creation We’vegrouped the measures into earnings, cash flow, and value categories, and will take
up each area in sequence
Earnings Measures
The five measures in this area are the traditional ways of stating earnings or ing earnings to different expressions of invested capital, which we discussed inChapter 4 They are being supplanted increasingly by cash flow and value-basedmeasures, especially for internal planning, analysis, and evaluation purposes Welist them here more for completeness than for their current relevance
relat-• Earnings per share (EPS) is accounting net income after taxes divided
by the number of shares outstanding
• Return on investment (ROI) is accounting profit divided by the bookvalue of the investment supporting the operations, both defined in avariety of ways
• Return on net assets (RONA), or return on capitalization, is after-taxaccounting operating profit (NOPAT) divided by the book value oftotal assets less current liabilities
• Return on capital employed (ROCE) is accounting operating profit(NOPAT) over the book value of assets supporting the operations
• Return on equity (ROE) is accounting net income after taxes divided
by the book value of shareholders’ equity
EPS, one of the most commonly quoted indices of performance, which
we discussed in several places in this book, has declined from its former eminence While still tracked by security analysts as an indicator of near-term per-formance, and used in simple valuation situations via the earnings multiple, EPSexpresses only the income side of the accounting spectrum Moreover, it is subject
pre-to the many rules of accounting that have moved performance data further andfurther away from cash flow In addition, the number of shares outstanding willfluctuate even more in these days of share buybacks, and will affect the level andtrend of this measure
ROI is the simplest way of expressing the profitability of asset use, and inits unadjusted form remains a basic accounting measure, not an expression of eco-nomic performance The accounting earnings reflect many noncash charges and
Trang 16additions, while the book value of the investment is a recorded value, not a rent economic value It might be useful as an approximation, but can often be un-reliable because of the nature of accounting data, as we mentioned in Chapter 4.RONA has become fairly popular, using a more focused operating profitrelated to the net assets, or capitalization, as recorded on the balance sheet It stillsuffers from some of the same accounting issues as ROI, especially in the valua-tion of the asset base.
cur-ROCE is a further modification, focusing on operating profit and operatingassets, but with similar accounting issues remaining Mostly applied to internalgoal setting, it helps to make asset utilization a performance issue, at least near-term It does not, however, relate well to economic measures used in judging newinvestments, nor does it assist in making day-to-day decisions on an economicbasis
ROE is the relationship of accounting net profit to the recorded residualownership claim of the common shareholders, a recorded value buffeted by awhole host of set-asides, reserves, and reclassifications Still widely quoted and attimes used in goal setting, the measure by its very nature cannot reflect the eco-nomic performance of a company Apart from the usual accounting issues it’s alsoaffected by the financial leverage employed by a company Beside the measure’sshortcomings for internal use, the leverage distortion makes peer comparisonsmore difficult, when capital structures vary
Cash Flow Measures
The more recent approaches to performance and value measurement are variably based on cash flow analysis, with much emphasis placed on removingaccounting allocations and noncash adjustments to arrive at cash provided by op-erations and cash invested to support the operations They relate closely to com-monly used economic criteria like net present value and internal rate of return,thus linking the economic approach to new investments with the assessment ofongoing operations We’ve discussed many of these already in earlier chapters,and will take up the most current ones later in this section
in-• Free cash flow is operating cash flow (net income after taxes plusdepreciation and amortization, but often adjusted to remove interestexpense), less new business investments (including changes in workingcapital) plus dispositions of assets
• Cash flow return on gross investment (ROGI) is operating cash flow(net income after taxes plus depreciation and amortization) divided
by gross assets (before accumulated depreciation)
• Cash flow return on investment (CFROI) is the internal rate of returnover the life of the investment, based on operating cash inflows, cashinvestment outflows, and cash recoveries It involves a variety ofadjustments to arrive at operating cash flows and the cash value
of the asset base involved, as we’ll demonstrate
Trang 17400 Financial Analysis: Tools and Techniques
• Total shareholder return (TSR) is the yield to the investor from sharesheld over one or several periods, calculated from the combination ofdividends and change in share value
• Total business return (TBR) is the internal rate of return from abusiness unit or unlisted company over one or several periods, fromthe combination of cash flows and change in capital value It involves
a variety of adjustments to develop beginning and ending values of thebusiness
Free cash flow has become a commonly accepted concept, useful as an nomic criterion for periodic results, but, even more importantly, representing akey element in the valuation of companies and their parts, as well as in strategicplanning analyses
eco-ROGI at times serves as a simple substitute for a periodic economic return,relating operating cash flows to recorded operating assets—which have been
“grossed up” by adding back accumulated depreciation to provide a surrogate forcurrent values of the asset base It can be a useful approximation to a more rigor-ous cash flow analysis in many situations, but could introduce some distortionsbecause in effect it relies on the original cost of assets of different ages as a broadsurrogate for current value
CFROI, in its most sophisticated form, is an economic return developed forthe company or its parts, representing an internal rate of return over the averagelife of the operating assets involved It’s directly comparable to the cost of capital,and to the results from cash-flow-based new investment analyses The methodol-ogy requires a series of adjustments and several conceptual constructs, as we’lldiscuss later
TSR has become a popular concept, used and published widely, because itexpresses the annual return achieved by an investor from holding a company’sshares over a specified period of time, based on dividends and change in marketvalue It links to a company’s cost of capital calculation as an expression ofthe shareholder expectations to be considered in establishing the cost of equitycapital
TBR is a parallel measure to CFROI, designed to measure the internal rate
of return of business units or other entities, based on free cash flow and estimates
of the beginning and ending values of the entity, much like the analysis of an vestment project as presented in Chapter 8
in-Value Measures
The seven value measures listed here similarly reflect the evolution from simplemultiples to present value cash flow concepts Again we’ve discussed several ofthe basic measures in earlier chapters, but later we’ll go into more detail about themost important ones for current value-based management practice
• Earnings multiples are based on total income after taxes or EPSmultiplied by a judgmental factor They are related to the price/earningsratio, which is often employed as a guide for the factor used
Trang 18• Cash flow multiples are a modification of earnings multiples, usingtotal income after taxes plus depreciation and amortization, or thesame on a per share basis, multiplied by a judgmental factor.
• Economic profit, or economic value added (EVA),* is the differencebetween operating profit after taxes (NOPAT) and a capital charge,which is based on the cost of capital times the net operating assetsemployed It’s also expressed as the change in economic profit fromperiod to period The measure requires a variety of adjustments tooperating profit and the asset base, as we’ll see
• Market value added (MVA) is the difference between the book value ofthe total invested capital and the market value of the various forms ofcapital It requires a variety of adjustments to the recorded values and
a careful judgment about how representative current share values are
• Cash value added (CVA) is the difference between the required annualcash flow to amortize an investment (using the cost of capital as thediscount factor), and the actual cash flows generated, expressed as
a present value differential
• Shareholder value (SHV), as we know, is the present value of theestimated future free cash flows over the planning period, discounted
at the company’s cost of capital, plus the present value of the ongoingvalue of the business, plus any nonoperating assets (such as marketablesecurities and other investments), less the amount of long-term debtoutstanding It represents the present value of shareholders’ equityunder the assumed conditions
• Shareholder value added (SVA) is the change in total shareholder value,either from period to period or over a longer planning time span, usingthe process of calculating shareholder value (SHV) as described abovefor each data point
Earnings multiples are still a popular way of establishing a “ball park” ure for the value of a business, even though accounting earnings are subject tomany potential distortions from an economic standpoint
fig-Cash flow multiples represent an effort to reflect operating cash flows, eventhough in their simplest form only depreciation and amortization is added back.Again, they are useful mainly as a first estimate before applying more sophisti-cated techniques
EVA, the concept popularized by Stern Stewart & Co., is a form of nomic profit derived from the excess (or deficit) of operating earnings after sub-tracting the cost of capital of the assets employed With a variety of adjustments
eco-to both operating profit and the asset base, this approach can be used eco-to trackchanges in value creation from period to period, and to establish a valuation ofthe company Economic profit is not a new principle, because in its basic form it
*EVA is a registered trademark of Stern Stewart & Co.
Trang 19402 Financial Analysis: Tools and Techniques
simply states that a company or a business unit is adding value when after-taxearnings before interest are higher than the weighted cost of capital of the re-sources employed in the creation of these earnings
MVA is an expression of the value created by a business in excess of theamount of the invested capital as shown on the balance sheet, on a periodic basis
as well as over a longer time span Given that the base is recorded capital, a ety of adjustments are required to make the measure meaningful
vari-CVA establishes the economic value created, in cash flow terms, over andabove the cash flows required to recover the capital employed in a business, usingthe cost of capital as a standard It closely parallels the net present value criterionand it is consistent with internal investment analyses
SHV is, of course, the familiar concept of letting expected cash flows resent the present value of shareholders’ equity as a measure of value creation ofthe total company Discussed in Chapter 11, this model of value representationunderlies much of the value-based management activity extant in modern corpo-rate America
rep-SVA has become a useful addition to the concept of total shareholder value,because of the importance of establishing trends in value creation when assessingcorporate strategic plans and their impact over a period of time It’s also used inassessing the value creation potential from combinations and acquisitions, aswe’ll see later
Economic Profit and CFROI
We’ll now discuss, in a little more detail, two of the most popular measures rently in use in value-based management processes As we’ve stated before, eco-nomic profit (EVA) represents a yardstick for measuring whether a business isearning above the cost of capital of the resources (capital base) it employs Thecalculation is a straightforward subtraction of the cost of capital from net operat-ing profit:
cur-EVA NOPAT Ck
where
NOPAT Operating profit after taxes (adjusted)
C Capital base employed (net of depreciation)
k Weighted average cost of capital
Note that the formula as stated relies on reported earnings and the recordedcapital base supporting these earnings, not on cash flows In effect, EVA is deter-mined by subtracting from operating earnings a capital charge for the book value
of the money invested in the company by owners and creditors For a businessunit, the capital charge is usually based on the net assets employed At first glance,EVA therefore appears to be more of an accounting-based than an economic
Trang 20measure In practice, however, Stern Stewart & Co makes a large series of justments when working with client companies These adjustments are made tocalibrate the measure more closely to an economic cash flow basis, in an effort toparallel the economic valuation concepts we discussed earlier (see the references
ad-at the end of the chapter) Moreover, the EVA approach is applied not only to suring current performance but also to measuring new investments and to devel-oping incentive compensation
mea-What are some of the key adjustments used in applying the EVA concept?Starting with the accounting statements of a company, the first step is to derive anadjusted NOPAT, while the second is the development of the relevant capital base.The major adjustments in the NOPAT and capital base calculations occur in thefollowing areas:
• Operating lease expenses
• Major research and development expenses
• Major advertising and promotion expenses
• Inventory value adjustment (LIFO)
• Deferred income taxes
• Goodwill amortization
• Separation of nonoperating assets
In the case of operating leases, an adjustment becomes necessary becausethere’s a preference for showing the unrecorded value of the leased assets as part
of the capital base, and removing the imputed interest expense on these leasedassets from the income statement The lease payments are capitalized on the bal-ance sheet, with an offsetting matching liability, and the capital value is amortizedover the appropriate time period This amortization expense is then subtractedfrom earnings in arriving at NOPAT
The effects of research and development as well as advertising and motion expenditures incurred in a given period often extend into future periods,although current accounting rules require the total expense to be charged to theperiod in which it was incurred The adjustment to NOPAT involves removingthese expenses from the income statement, capitalizing them as part of the capitalbase, and amortizing them over an appropriate time period This periodic amorti-zation, a smaller amount, is then subtracted from earnings in arriving at NOPAT.Inventory values under LIFO can, over time, become understated becausethe recorded cost of the earlier items in inventory remains unchanged, whilerecent additions are charged into cost of goods sold To adjust for this disparity,inventories on the balance sheet are restated to current higher values, with anoffsetting increase to earnings This adjustment also is referred to as adding backthe change in the LIFO reserve
pro-Deferred income taxes, as we discussed in earlier chapters, arise from ing differences between taxes due on corporate tax returns and those reflected on
Trang 21tim-404 Financial Analysis: Tools and Techniques
the books In an effort to represent the cash taxes actually paid during a period, thechange in deferred taxes is added or subtracted in the revised NOPAT calculation.Finally, where sizable goodwill amounts are carried on the balance sheet,the periodic amortization reflected on the income statement is reversed so thatearnings are higher Goodwill remains unchanged on the balance sheet, on the as-sumption that this asset is a permanent part of the capital base
In most cases, the net effect of these adjustments will result in a somewhathigher NOPAT and an expanded capital base, but not necessarily in proportion totheir impact on the EVA calculation
How is the result of the EVA calculation to be interpreted? There are twoways of looking at the outcome The first is an absolute determination of whetherperiodic earnings have exceeded or fallen short of earning the cost of capital.The second interpretation tracks the change from period to period, to reflect theamount of value creation For example, let’s assume that in 1999 a company fellshort of earning the cost of capital by $200 million, but in 2000 achieved a posi-tive economic profit of $50 million Under the first interpretation, economic profitwas highly negative in 1999, and positive in 2000 Under the second interpre-tation, the company’s management created $250 million of economic profitbetween 1999 and 2000, by having reversed the negative results of 1999 into pos-itive territory in 2000 From a value-based management standpoint, both inter-pretations are used, the first usually for goal setting in operations, planning, andinvestment, and the second as an incentive to bring about change As we’ll seeshortly, such economic profit analyses are best viewed over several periods,because being modified accounting results they are subject to some of the sameperiod-to-period distortions as unadjusted accounting measures
CFROI, the most sophisticated and empirically grounded methodology forvalue-based management, was developed over many years of statistical analysis
by the former HOLT Value Associates, now functioning both as a part of TheBoston Consulting Group and separately as Holt Value Associates LP This cash-flow–based approach, originally intended as an analytical guide for portfolio man-agers, is based on translating a company’s financial results through a variety ofadjustments into a current-dollar cash flow return on investment (CFROI) mea-sure, which expresses the company’s economic performance This concept, whenapplied to expected cash flows and combined with projected growth in the com-pany’s asset base, can then be used in a proprietary analytical model to calculatethe company’s market value The HOLT model recognizes the adjusted cash flowcontributions from existing assets and combines them with new investment cash
flows, all on a comparable economic basis This culminates in the concept of cash
value added (CVA), which amounts to finding the economic value created by
suc-cessful business strategies and investments over and above earning the cost ofcapital on a discounted cash flow basis
In effect, the HOLT model transforms a company’s financial data into aconsistent series of economic “project” cash flows that, when discounted at anempirically derived investor’s return standard (generalized cost of capital for the
Trang 22market as a whole), permits calculation of the relative market value of the pany’s capitalization In most cases, the calculated share values not only trackvery closely with historical price patterns but also become predictors for an ex-pected market value based on a company’s strategic plans—if the assumed plancash flows are realized in the future, of course The model is a highly integratedand sophisticated application of the economic cash flow principles we’ve dis-cussed throughout this book (see the references at the end of the chapter for addi-tional reading).
com-The CFROI performance measure itself can be illustrated by the diagram inFigure 12–5, where the data are taken from the financial statements of a companyafter a variety of adjustments, some similar to the ones we described for the EVAprocess In contrast to EVA, however, the approach is strictly cash flow based, andthe data are adjusted to a current-dollar basis Note that the diagram is a presentvalue analysis of the current value of the gross investment in the company, a levelcash flow projection over 12 years, the average asset life assumed, and the value
of nondepreciating assets recovered at the end of 12 years In this example, theresult is an internal rate of return of 20 percent, which represents the cash flowreturn earned by the company in the current year The reason the cash flow patternwas extended over the assumed average life of the assets and a recovery was pro-vided is simply that the CFROI concept is designed to parallel the familiar newproject economics cash flow patterns we discussed in Chapters 7 and 8 There weemphasized that the economic life and any recoveries must be taken into account
to be able to calculate an internal rate of return The CFROI result expresses onlythe performance for the year under analysis The CFROI for the next year would
be based on that year’s cash flows, extended over the assumed asset life, usingasset values adjusted as necessary for the current investment as well as for theassumed capital recovery at the end, and the process is repeated for ensuing years
Result: CFROI is 20%
(the internal rate of return of this cash flow pattern) Average asset life assumed: 12 years Annual aftertax adjusted cash flow before interest: $800 (Current-year cash flow assumed to continue)
Trang 23406 Financial Analysis: Tools and Techniques
The adjustments underlying the data in Figure 12–5 are made in three areas.The first involves transforming accounting net income into a gross cash annualflow The following changes were made:
Accounting net income: $425 Add back depreciation effect, other noncash charges 200 Add back tax-adjusted interest expense 75 Add back tax-adjusted operating lease expense (see below) 50 Adjust for inventory valuation (LIFO reserve) 40 Adjust for inflation 10 Current dollar gross cash flow: $800
When appropriate, adjustments to add back unusual advance expenditures onresearch and promotion also are made Note the inflation adjustment, which cur-rently is not large in U.S companies, but can be significant in other economies.The second area involves transforming recorded assets into a current cashvalue investment base The following changes were made:
Recorded total assets: $3,125 Add back accumulated depreciation to arrive at original cost 950 Adjust gross fixed assets for current dollar value 575 Capitalize operating leases to show imputed asset value 350 Subtract non-interest-bearing liabilities (1,100) Subtract goodwill (300) Current dollar gross cash investment: $3,600
Note that the adjustment to transform the original cost of fixed assets into acurrent-dollar equivalent is a significant amount, which is based on choosingappropriate inflation measures Non-interest–bearing liabilities, such as accountspayable, accruals, taxes payable, and other noncontractual liabilities, are subtracted
to arrive at a modified net asset figure Importantly, goodwill is subtracted as relevant to the economics of this calculation, because the fixed asset adjustment
ir-to current values stands as a surrogate for goodwill arising from the premium paidfor purchased assets
The third area involves the development of a cost of capital standard in real(noninflationary) terms, which is based on a real risk-free interest rate, a real stockmarket premium, and a real interest cost of debt The HOLT methodology uses amarket-based cost of capital in those terms, rather than a company-specific cost ofcapital as discussed in Chapter 9, on the assumption that individual company risk() is expressed in the expected cash flow performance.
As we mentioned earlier, the CFROI calculation is one of the measures used
in the HOLT methodology to judge whether a company is performing above thecost of capital in any given period Because it’s a strictly cash-based measure,CFROI is directly comparable to the cost of capital criterion CFROI reappears inthe HOLT methodology as part of an overall performance profile which linksCFROI performance, past and projected investment growth, and competitive im-pact into a valuation framework that expresses past and prospective share price
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Trang 24performance The competitive impact is recognized in the form of a fade effect(reducing extraordinary results over time as unsustainable), and is incorporatedinto the judgment about the ongoing value of the business We’ve given only abrief overview of this highly integrated methodology here; for more informationthe reader should turn to the references at the end of the chapter.
How can we compare economic profit and CFROI with some of the othermeasures? The table in Figure 12–6 is a highly simplified example of how the var-ious approaches apply in the case of a company with an initial investment of
$12 million, including $2 million of working capital, level net operating profitafter taxes (NOPAT) of $825,000, and an economic life of eight years We’ll as-sume that no additional investments are required, that the working capital will berecovered in Year 8, and that all excess cash is paid out to the owners In a real sit-uation there would be more complex conditions, but for purposes of illustrationthis stripped-down example will provide acceptable indications
First we show an economic profit analysis, in which a cost of capital charge
of 10 percent is applied to the declining book value of the investment base Thischarge is offset against the level annual NOPAT of $825,000 Note that during thefirst three years the economic profit is negative, with breakeven achieved in Year
4, and with growing positive amounts in the remaining years Given that we’veassumed a level annual NOPAT, this pattern is not surprising, because the capitalcharge is being applied every year to a declining investment base When we use a
10 percent discount rate to the individual annual economic profit results, the netpresent value is 0, suggesting that in this simplified example the company is earn-ing exactly its cost of capital
The same result is achieved when we proceed with a basic CFROI analysis
as shown in the middle of the table First we move from accounting NOPAT to
a periodic operating cash flow by adding back the noncash depreciation effect,arriving at a level $2.075 million This parallels the approach we used with newinvestment projects, as described in Chapters 7 and 8 Moving on, we find that inthis instance the investment base does not decline, because we are recovering theinitial cash investment from future cash flows via a level capital charge plus alevel capital amortization The former is simply a 10 percent charge against theinitial investment base The second, in effect, represents an annuity that will build
up to a future value of $12 million at 10 percent in Year 8, an amount sufficient torecover the initial investment Note that the combined capital charge and capitalamortization is exactly equal to the operating cash flow of $2,075 million, indi-cating that the internal rate of return of this business is exactly 10 percent.The major difference between the economic profit and the cash flow returnapproaches is the respective periodic patterns and their interpretation Note thatthe end results are the same, namely a net present value of zero and an internalrate of return of 10 percent The meaning of the periodic elements as shown, how-ever, is quite different, because in the case of economic profit we’re observing anadjusted accounting profit as well as a declining capital base as reflected on thebooks of the company In the case of CFROI we are dealing with after-tax cashflows in every instance that over time provide a recovery of the investment and a
Trang 25An Illustration of Economic Profit, CFROI, and Earnings Measures (thousands of dollars)*
Economic Profit Analysis Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Book value of fixed investment (beginning) — $10,000 $ 8,750 $ 7,500 $ 6,250 $ 5,000 $ 3,750 $ 2,500 $ 1,250
Economic profit (EVA) — 375 250 125 0 125 250 375 500
Net present value of economic profits @ 10% –0–
Cash Flow Return on Investment Analysis
NOPAT — 825 825 825 825 825 825 825 825
Add back depreciation effect — 1,250 1,250 1,250 1,250 1,250 1,250 1,250 1,250
Operating cash flow generated — 2,075 2,075 2,075 2,075 2,075 2,075 2,075 2,075
Initial investment 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000
Cost of capital — 10% 10% 10% 10% 10% 10% 10% 10%
Capital charge @ 10% — 1,200 1,200 1,200 1,200 1,200 1,200 1,200 1,200
Capital amortization @ 10% — 875 875 875 875 875 875 875 875
Total cash flow required $ 12,000 $ 2,075 $ 2,075 $ 2,075 $ 2,075 $ 2,075 $ 2,075 $ 2,075 $ 4,075
Present value of future cash flows 12,000
Net present value @ 10% –0–