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384 Financial Analysis: Tools and Techniques The added difficulty of forecasting operations beyond the end of the chosen analysis period suggests that we also find an acceptable shortcut answer for the ongoing value. A common way of dealing with the problem is to use a price to earnings multiple that might be warranted at that point, i.e., to set the value of the business 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 business and 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 an initial valuation result. At times the ongoing value is simply represented by the estimated book value of the business, although this is probably a less satisfac- tory shortcut than the earnings multiple for the reasons we discussed in earlier chapters. 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 annual net cash flows (free cash flow) represent the cash available to the company to support its obligations to all providers of the long-term funds, i.e., the payment of FIGURE 11–5 Total Company Valuation—A Numerical Example* Present Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 EBIT (1 Ϫ 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 . . . . . . . . . . . . . . . . . . . Ϫ1,200 Ϫ1,400 Ϫ1,800 500 Ϫ1,600 Ϫ2,000 Less: net new capital investments. . . . . . . . . . . . . . . Ϫ8,000 Ϫ15,000 Ϫ10,200 Ϫ11,000 Ϫ22,000 Ϫ10,000 Add/less: significant nonoperating items . . . . . . . . . 500 Ϫ300 400 1,200 Ϫ800 0 Free cash flow . . . . . . . . . . . . 7,800 2,300 10,000 12,000 Ϫ1,000 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 Ϫ567 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 *This exhibit is available in an interactive format (TFA Template)—see “Analytical Support” on p. 389. hel78340_ch11.qxd 9/27/01 11:31 AM Page 384 CHAPTER 11 Valuation and Business Performance 385 interest, dividends, and potential repayment of debt or even repurchase of its own shares. After discounting the pattern of annual cash flows over the chosen time frame at the appropriate return standard, normally the weighted average cost of capital, the resulting net present value should be a reasonable approximation of the value of the total business. Note that the nonoperating assets were added to the 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 that were used in deriving it. The analyst should employ extensive sensitivity analysis to test the likely range of outcomes, testing different discount rates and especially different 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 cash flow estimate of $12 million, divided by the cost of capital of 12 percent. With a five 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 discount factor in Year 6 at 12 percent is 0.507), the discounted difference between the earnings multiple assumption of $187.5 million we used, and the no-growth free cash flow result of $100 million is still a highly significant $44 million ($87.5 ϫ 0.507), or about one-third of the final result. It’s not unusual to find such sizable ranges of outcomes in what amounts to a quantification of future expectations, not historical data. It’ll be useful to demonstrate visually how the firm value developed by this present value analysis relates to the company’s capital structure. What we’ve developed by discounting the net cash flow stream and the assumed ongoing value, plus nonoperating assets, is the approximate fair market value of the com- pany’s overall capitalization. Figure 11–6 demonstrates that the total recorded value 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 present value 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 recorded values 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 by coincidence will the two values be precisely equal, because as we discussed in Chapter 2, recorded values on the balance sheet reflect historical transaction values 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 present value 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 share- 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 we discussed earlier in this chapter, rather than the recorded values on the balance sheet. For example, if current interest rates are higher than the stated rates for the company’s debt, the value of the debt will be lower than recorded, and vice versa. hel78340_ch11.qxd 9/27/01 11:31 AM Page 385 386 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 mea- sure which contains the cost of incremental debt, as we recall from Chapter 9. A similar deduction must be made for any preferred stock contained in the capital structure. We’ve now achieved a direct valuation of the company’s common equity by means of an economic (cash flow) approach which is conceptually superior to the simpler devices discussed in the common stock section of this chapter, although subject to the range of assumptions underlying it. This approach is the basis for much 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 developing operating cash flow patterns for each of the business units, and discounting these individual patterns at the corporate cost of capital. If the businesses differ widely in their risk/reward conditions, one can apply different discount standards that reflect 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 involving the sale of a company or any of its parts. Different analysts and certainly buyers and sellers will use their own sets of assumptions in developing their respective FIGURE 11–6 Present Value of Business Cash Flows and the Capital Structure Assets Liabilities Company book value History Expectations Current assets Current liabilities Long- term debt Working capital Fixed assets Other assets Share- holders’ 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… hel78340_ch11.qxd 9/27/01 11:31 AM Page 386 TEAMFLY Team-Fly ® CHAPTER 11 Valuation and Business Performance 387 results. There should also be efforts to test the analytical results against compa- rable transactions, to the extent these are available and relevant. 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 differ- 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’ll return to the subject of valuation of a company or combination of companies within the context of shareholder value creation in Chapter 12. Using Shortcuts in Valuing an Ongoing Business In the previous example, an earnings multiple based on EBIT was used to derive the 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 as well. 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 nego- tiations. Never precise, the earnings multiple is derived from rough statistical comparisons of similar transactions, and from a comparative evaluation of the performance 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 estimated customer group. 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 sell- ing price—assuming that the earnings chosen are representative of what the future will bring. When taken as only one of the indicators of value within a whole array of negotiating data, the earnings multiple and the related crude rate of return have some merit. Other shortcuts in valuing an ongoing business involve determining the total market value of common and preferred equity from market quotations—in itself 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 issue involved 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 the business is examined as an indicator of value. Needless to say, the fact that recorded values don’t necessarily reflect economic values can be a significant problem. 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 the particular case. In most situations, the discounted cash flow approach will be the conceptually most convincing measure, despite the difficulties of estimating the cash flow pattern in specific terms. hel78340_ch11.qxd 9/27/01 11:31 AM Page 387 388 Financial Analysis: Tools and Techniques Key Issues The following is a recap of the key issues raised directly or indirectly in this chap- ter. They are enumerated here to help the reader keep the techniques discussed within the perspective of financial theory and business practice. 1. The concept of value is not independent of the purpose for which it is used, and its definition and meaning can vary widely with respect to the conditions and circumstances to which it is applied. 2. The value of a security is a function of the expectations about future performance placed upon it, which can be individual judgments as well as collective judgments representing a market. 3. Investors approach the valuation of an investment proposition in terms 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, the relative value of a share of common stock in the market at any time is a combination of future expectations, residual claims, and assessments of general and specific risk, subject to economic and business conditions and the decisions of management and the board of directors. It’s also affected by the breadth of trading in the security. 5. Valuation techniques are essentially assessment tools that attempt to quantify available objective data and estimates. Yet such quantification will always remain in part subjective, and in part impacted by forces beyond the individual parties’ control. 6. Valuation of a security or a business is distorted by the same elements that 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 to await actual performance in the future; this is why the importance of sound 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 tech- 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 main forms of securities issued by a company. After covering both value and yield in these situations, we expanded our view to encompass the valuation of an ongoing business. Our purpose was to find basic ways of setting the value in transactions such as sale of a business, restructuring, or the combination of companies in the form of a merger or acquisition. hel78340_ch11.qxd 9/27/01 11:31 AM Page 388 CHAPTER 11 Valuation and Business Performance 389 We found that methods were available for deriving such values, but that the specific assumptions and the background of the transaction added many, often complex, dimensions to the basic calculations. We demonstrated the valuation of a business specifically in cash flow terms, and showed how a company’s equity can be valued based on cash flow expectations, quite similar to the business in- vestment analysis we discussed in Chapter 8. Ultimately, value will always remain partially subjective and will be settled in an exchange between interested par- ties—but managing effectively for economic performance and value will always remain 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 inte- grated financial projections directly from input data and built-in data bases, using the application’s forecasting capabilities. It can automatically derive accounting measures as well as common cash flow inputs to valuation analysis. The software is also accompanied by an interactive template (TFA Template under “extras”) for the cash flow valuation of a business, based on Figure 11–5 on page 384, which can be used to calculate present values and the equity valuation for any pattern of inputs and discount rates. The historical database on TRW Inc. contained in the software 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) Selected References Brealey, Richard, and Stewart Myers. Principles of Corporate Finance. 5th ed. Burr Ridge, IL: Irwin/McGraw-Hill, 1996. Copeland, Tom; Tim Koller; and Jack Murrin. Measuring and Managing the Value of Companies. 2nd ed. New York: John Wiley & Sons, 1995. Cornell, Bradford. Corporate Valuation: Tools for Effective Appraisal and Decision Making. Burr Ridge, IL: Business One Irwin, 1993. Jones, Gary E., and Dirk Van Dyke, The Business of Business Valuation. Burr Ridge, IL: McGraw-Hill, 1998. Pratt, Shannon P. Valuing a Business: The Analysis and Appraisal of Closely Held Com- panies. 3rd ed. Burr Ridge, IL: Irwin/McGraw-Hill, 1995. Rappaport, Alfred. Creating Shareholder Value. Revised ed. New York: Free Press, 1998. Ross, Stephen; Randolph Westerfield; and Jeffrey Jaffe. Corporate Finance. 5th ed. Burr Ridge, IL: Irwin/McGraw-Hill, 1999. Weston, Fred; Scott Besley; and Eugene Brigham. Essentials of Managerial Finance. 11th ed. Hinsdale, IL: Dryden Press, 1996. hel78340_ch11.qxd 9/27/01 11:31 AM Page 389 This page intentionally left blank. CHAPTER 12 MANAGING FOR SHAREHOLDER VALUE We now return to the primary concept we established at the beginning of this book, namely, that the basic obligation of the management of any company is to make investment, operating, and financing decisions that will enhance share- holder value over the long term. Our discussion of valuing business cash flows in Chapter 11 strongly suggested that management should periodically reexamine the 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 shareholder value depends on making new investments that exceed the cost of capital—an ex- pression of investor expectations—as well as managing all existing investments for cash flow results that similarly exceed investor expectations. The most beneficial aspect of the growing emphasis on shareholder value creation over the past decade has been the widespread rediscovery of management fundamentals—even if at times under threat of dismissal by hostile raiders. De- spite the periodic lapses of economic discipline exemplified in the recent dot.com bubble, which we discussed in Chapter 1, there has been real progress made with the prospect of more to come. Growing numbers of corporate managers, in the U.S. and in other parts of the world, are tackling the critical task of creating value for 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 making their decisions, large and small, on the basis of sound economic trade-offs. The basic imperative of requiring all investments to earn above the cost of capital has been rediscovered as a practical—even if difficult to achieve—goal. Vast efforts at restructuring, increasing cost-effectiveness, making disinvestments and acqui- 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 the relative contribution from various business segments with an objective “outside” orientation has become commonplace in many companies. One could argue that 391 hel78340_ch12.qxd 9/27/01 11:32 AM Page 391 Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use. 392 Financial Analysis: Tools and Techniques this approach should really have been commonplace all along, because of the long-established fact that all business decisions have an economic basis—whether this is recognized or not. Anumber of specialized measures and valuation method- ologies have emerged in support of value-based management principles, which we’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 FIGURE 12–1 Shareholder Value Creation in a Business System Context Dis- investment Depreciation effect Interest (tax-adjusted) Dividends paid New investment Leverage VolumePrice 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 hel78340_ch12.qxd 9/27/01 11:32 AM Page 392 CHAPTER 12 Managing for Shareholder Value 393 overview perspectives in Figures 12–2 and 12–3 also will help set the stage for this chapter. As the upper part of the diagram shows, companies focusing on share- holder value will tailor their analytical processes and physical implementation to achieve economic (cash flow) returns above the cost of capital on new in- vestments as well as on existing investments, making sure that return goals are set 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 this area, 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 accounting data and recorded values are the main source of information. It is here where much of the development of value-based methodologies has taken place, in an effort to close the conceptual gap between cash flow economics and ratio-based conventional analysis. The midsection of the diagram reflects our familiar set of operational trade- offs, which in a value creation context, should be made with long-term cash flow generation 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 of their cash flow impact, but also measures and incentives that reinforce economic decision making. Again, the increasing emphasis on value-based management is fueling a shift away from accounting-based methodology toward cash flow frame- works. We encountered some of this trend in our discussion of the analytical approaches of earlier chapters, and we’ll expand on the measures and their impli- cations later in this chapter. The bottom part of the diagram deals with the financing aspects of value creation, where we recognize the many trade-offs we’ve encountered in Chap- ters 6, 9, and 10. Companies with a value orientation consciously manage these trade-offs for long-term cash flow generation, and view the disposition of profits and the target dimensions of the capital structure as critical supportive elements in their strategic planning. Choices that affect dividend payout, changes in leverage, repurchase of shares, and funding of future opportunities are made against the criterion of value creation. The trade-offs chosen here can at times significantly affect the direction of the company’s strategy. Another overview of the integration of financial, strategic, and operational activities 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 by the key management activities, starting at the top with the evaluation and selection of sound strategies, leading to broad resource allocation and the analysis of spe- cific business investments. In this area the analytical tools of Chapters 7 and 8 come 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 hel78340_ch12.qxd 9/27/01 11:32 AM Page 393 [...]... patterns that are the economic underpinning of performance and value All financial analysis 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, hel78340_ch12.qxd 9/ 27/01 11:33 AM Page 396 396 Financial Analysis: Tools and Techniques AM FL Y and it’s important that the analytical use of any measure,... hel78340_ch12.qxd 9/ 27/01 11:33 AM 398 Page 398 Financial Analysis: Tools and Techniques performance and value criteria that reflect and encourage the cash flow trade-offs underlying management decisions, incentives, execution, and results A Review of Key Measures At this point we should review in broad terms the key performance and value measures encountered in current business practice, and to comment... 199 9 a company fell short of earning the cost of capital by $200 million, but in 2000 achieved a positive economic profit of $50 million Under the first interpretation, economic profit was highly negative in 199 9, and positive in 2000 Under the second interpretation, the company’s management created $250 million of economic profit between 199 9 and 2000, by having reversed the negative results of 199 9...hel78340_ch12.qxd 9/ 27/01 11:33 AM Page 394 394 Financial Analysis: Tools and Techniques F I G U R E 12–2 Shareholder Value Creation in a Management Context Seek and evaluate sound strategies Manage capital structure proportions Manage business portfolio balance and size Balance shortversus long-term viewpoints Allocate resources to strategies... well-established company acquires a new and fast-growing company, the market value assessment of the acquirer’s stock is likely to be more reliable than that of the candidate, whose stock might be thinly traded and unproved, or it might reflect excessive speculation But even if they had comparable market hel78340_ch12.qxd 9/ 27/01 11:33 AM Page 416 416 Financial Analysis: Tools and Techniques exposure, the inherent... value gap is the difference between the present value of the company’s projected cash flows under existing conditions, and the present value of a different and usually higher cash flow pattern expected from hel78340_ch12.qxd 412 9/ 27/01 11:33 AM Page 412 Financial Analysis: Tools and Techniques the restructured company The attraction for the acquirer in a corporate takeover is to realize the potential... adjustments to both operating profit and the asset base, this approach can be used to track changes in value creation from period to period, and to establish a valuation of the company Economic profit is not a new principle, because in its basic form it *EVA is a registered trademark of Stern Stewart & Co hel78340_ch12.qxd 9/ 27/01 11:33 AM 402 Page 402 Financial Analysis: Tools and Techniques simply states that... the more difficult areas of financial analysis that must be practiced with complex integrative situations Such detailed case examples go beyond the scope of this book, but they can be readily found in more extensive finance texts and case books, such as we’ve listed at the end of each chapter hel78340_ch12.qxd 9/ 27/01 11:33 AM Page 418 418 Financial Analysis: Tools and Techniques To round out our... CFROI 6 .9% 6 .9 17.3 10.0 7.7% 7.7 17.3 10.0 *This exhibit is available in an interactive format (TFA Template)—see “Analytical Support” on p 423 8.7% 8.7 17.3 10.0 10.0% 10.0 17.3 10.0 11.8% 11.8 17.3 10.0 14.3% 14.3 17.3 10.0 18.3% 18.3 17.3 10.0 25.4% 25.4 17.3 10.0 Financial Analysis: Tools and Techniques Initial investment ... separation of the two approaches, F I G U R E 12–7 The Divergence of Accounting and Cash Flow Measures Rate of return Project/business internal rate of return Cost of capital Positive net present value over the economic life Accounting return on assets 0 Time n hel78340_ch12.qxd 9/ 27/01 11:33 AM Page 410 410 Financial Analysis: Tools and Techniques F I G U R E 12–8 Another View of Accounting vs Cash Flow Performance . elements and vari- ables that drive value creation, which form the basis for operational targets and the hel78340_ch12.qxd 9/ 27/01 11:32 AM Page 393 394 Financial Analysis: Tools and Techniques measures. Free cash flow Profit Profit Sales Costs Current asset values Cash flow % CFROI hel78340_ch12.qxd 9/ 27/01 11:33 AM Page 397 398 Financial Analysis: Tools and Techniques performance and value criteria that reflect and encourage the cash flow trade-offs underlying. effective- ness Debt; equity; leverage; payout repurchase Working capital; facilities; programs Discount rate Cost of capital The investor hel78340_ch12.qxd 9/ 27/01 11:33 AM Page 395 396 Financial Analysis: Tools and Techniques and it’s important that the analytical use of any measure, or