0521519071 cambridge university press sources of value a practical guide to the art and science of valuation jun 2009

This page intentionally left blank Sources of Value Sources of Value is a comprehensive guide to financial decision-making suitable for beginners as well as experienced practitioners It treats financial decision-making as both an art and a science and proposes a comprehensive approach through which companies can maximise their value Beginners will benefit from its initial financial foundation section which builds strong basic skills Practitioners will enjoy the new insights which the eponymous Sources of Value technique offers – where value comes from and why some companies can expect to create it while others cannot The book also introduces several other techniques which, together, spell out how to combine strategy with valuation and an understanding of accounts to make a fundamental improvement in the quality of corporate financial decision-taking Sources of Value is written in a readable conversational style and will appeal to those already working in companies as well as those studying on a business course Simon Woolley is a Fellow of Judge Business School, University of Cambridge and Managing Director of Sources of Value Ltd He has had a long career with the oil major BP, working in a number of roles related to investment valuation and financial training, culminating in the position of Distinguished Advisor – Financial Skills Sources of Value A Practical Guide to the Art and Science of Valuation Simon Woolley CAMBRIDGE UNIVERSITY PRESS Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo Cambridge University Press The Edinburgh Building, Cambridge CB2 8RU, UK Published in the United States of America by Cambridge University Press, New York www.cambridge.org Information on this title: www.cambridge.org/9780521519076 © Simon Woolley 2009 This publication is in copyright Subject to statutory exception and to the provision of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press First published in print format 2009 ISBN-13 978-0-511-53980-0 eBook (EBL) ISBN-13 978-0-521-51907-6 hardback ISBN-13 978-0-521-73731-9 paperback Cambridge University Press has no responsibility for the persistence or accuracy of urls for external or third-party internet websites referred to in this publication, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate Contents List of figures Preface Acknowledgements Section I  The five financial building blocks Building block 1: Economic value Building block 2: Financial markets Building block 3: Understanding accounts Building block 4: Planning and control Building block 5: Risk page vii ix xvii 28 62 99 142 Section II  The three pillars of financial analysis 181 10 183 188 258 341 387 Overview The first pillar: Modelling economic value The second pillar: Sources of Value The third pillar: What sets the share price? Conclusion Section III  Three views of deeper and broader skills 393 11 12 13 14 395 462 523 561 v First view: The cost of capital Second view: Valuing flexibility Third view: When value is not the objective Overall conclusions vi Contents Appendices  Individual work assignments: Suggested answers I Building block 1: Economic value II Building block 2: Financial markets III Building block 3: Understanding accounts IV Building block 4: Planning and control V Building block 5: Risk Glossary Bibliography Index 569 571 574 582 587 594 603 613 615 Figures 1.1 The economic value model 1.2 Typical value profile for a project 1.3 Effect of discount rate on present value 2.1 The capital asset pricing model 4.1 From strategy to actuals 4.2 Plan, Do, Measure, Learn 4.3 The value chain model 4.4 The five forces model 4.5 The McKinsey/GE matrix 5.1 Example of a frequency distribution 5.2 Example of a skewed distribution 5.3 Example of a cumulative probability distribution 5.4 Example of a simple decision tree 5.5 Property development decision tree 5.6 Sensitivities: scaffolding project 5.7 How diversification reduces volatility 5.8 A second look at the capital asset pricing model 5.9 The U-shaped valley of risk 5.10 Comprehensive risk framework 7.1 US$ to GB£ exchange rate July 2006–June 2007 8.1 Example of a Sources of Value diagram 8.2 Linking Sources of Value to strategic thinking 8.3 Example of a cost curve 8.4 The shape of cost curves 8.5 The evolution of a cost curve 8.6 Scaffolding project: initial Sources of Value analysis 8.7 Real example of a cost curve: copper cash operating cost 2006 – no credits 8.8 Components of value map: ‘me too’ player’s project vii page 15 15 49 108 109 116 118 123 147 148 149 152 152 159 163 167 171 175 230 262 272 273 277 280 289 295 319 viii List of Figures 8.9 Sources of Value chart for a typical acquisition 8.10 The project life cycle 9.1 Continuous good surprises 9.2 Continuous good surprises achieved via step changes 10.1 Cumulative present value: the project person’s view 10.2 Cumulative present value explained through Sources of Value analysis 10.3 Shareholder value and cumulative present value over a project’s life 10.4 The fish diagram: shareholder value and cumulative present value over a project’s life 11.1 Aide-mémoire: the economic value model 11.2 US 90 day T bills and inflation 11.3 Example yield graph September 2002 11.4 Example yield graph September 2006 12.1 The four types of flexibility 12.2 Paths into the future 12.3 Valuing the tail 12.4 Valuing the tail: triangular distribution 12.5 Swimming pool cover project 12.6 Swimming pool cover project with ‘perfect’ survey 12.7 Swimming pool cover project with ‘80/20’ survey 13.1 The prism approach 14.1 The linkages between strategy, accounts and value 325 337 380 381 388 390 390 391 397 401 403 404 467 481 503 504 510 511 512 541 565 610 Glossary Risk In the context of this book the word risk usually refers to the fact that uncertainty exists as regards what will happen in the future Note the contrast with the idea that risk might simply be associated with nasty outcomes Risk-free rate The rate of return which investors require in order to justify investing in a situation where there is no risk ROCE bridge An explanation for the link which exists between the project’s IRR and the accounting return on capital employed which a company will earn if it simply invests in a stream of projects like this one The relationship helps to explain why companies need over time to earn a ROCE of above their cost of capital if they are to create value for shareholders Search costs The cost of, for example, R&D, exploration or a project development team that has searched for and found an opportunity which is now being ­considered Sensitivities or sensitivity analysis Calculating the financial consequences for a project should different assumptions be made Sensitivities are usually reported as impacts on one or more of the economic indicators such as NPV or IRR Sources of Value The eponymous technique which allows a project’s NPV to be explained by reference to two factors These are the value calculated for its individual sources of value and the value anticipated for the deemed ‘me too’ player The technique creates a bridge between finance and strategy and offers great insights into NPVs Stage gate processes A way of aiding the efficient implementation of a project by breaking it down into key stages Each stage is characterised by its own key aims and work on one stage should not start until the previous stage has been completed Various versions of the process exist and typical stages would be: options identification and selection; detailed design; implementation; operation Standard methodology The discounting conventions through which senior decision-makers can be assured that they can compare investments based on their actual merits and not have to worry about spurious methodological differences This can only be done when all those involved in calculating economic indicators adopt a standard methodology which defines the approach to discounting and makes it clear where assumptions must stop and a standard approach must start (See also Level playing field.) Strategy The overall direction in which a company is trying to go Note the distinction between a strategy options study which considers the alternatives open to a company and an agreed strategy which describes the chosen course For most companies corporate strategy will describe the choice of businesses that the company invests in and the way that it organises 611 Glossary and manages itself Each individual business will have its own strategy which describes how it intends to beat its own competitors Success value The value of a set of financial projections which are based on a presumption of success in relation to some key aspect such as winning an auction Success values can be contrasted with expected values which incorporate also the possibility and impact of failure Sunk costs At any point in time this refers to money that has already been spent on a project Sustaining investment Relatively small amounts of investment which are necessary in order to protect against a substantial drop in output from an existing plant The usual analogy is the need to replace a pump should it fail This might count as capital expenditure but the justification would be different from justifying a major new build The appropriate approach is to justify a programme of sustaining investment and not each individual item Terminal value A terminal value is used when an economic evaluation is deliberately carried out for a period of less than the full life of an asset The cash flows beyond this period are replaced with a calculated terminal value which represents the present value as at the end of the period which has been explicitly modelled on cash flows expected beyond this point Terminal values are usually used when valuing entire companies Time value of money The extra amount of money that is required in order to justify receiving money later rather than now This is stated as an annual percentage and is also often referred to as the cost of capital or the discount rate Types of sensitivity This book proposes the use of three different types of sensitivity Type should show the impact of changes in assumptions to the P10/P90 range Type should show what changes are necessary in order to have a zero NPV Type should show any other relevant ­information U-shaped valley A description adopted by this book for the approach of incorporating the consideration of risk into the development of a project The approach has three steps First one calculates a first-cut estimate of NPV based on single-point assumptions corresponding to a successful outcome Then one assesses the risks to this (both upside and downside) on an impact times probability basis This provides the floor of the so-called U-shaped valley Then finally one considers actions which can be taken in advance to mitigate the risk Value chain model An approach proposed by Professor Michael Porter under which the activities of any company can be divided into five primary and four support activities The approach gives a disciplined framework for considering the activities of a company and how it compares with its competitors 612 Glossary Value creation The positive NPV caused when a new plan or project is identified Value growth An increase in value that happens over a period of time This is a potentially dangerous concept because one cannot know whether value growth is good or bad unless one also knows how much money was invested in a company or withdrawn from it between the dates of the two valuations Value profile A graph which depicts the cumulative present value of a project over its anticipated life Value sector That part of the overall economy that is made up of companies that take the maximisation of shareholder value as their primary objective The individual companies in the sector can be termed value players Weighted average cost of capital (WACC) Another term for cost of capital The term places emphasis on the fact that the cost of capital is indeed the weighted average cost of the various forms of finance which a company uses Words and music A technique suggested in this book which emphasises the links which should exist between a strategy (the words) and its financial results (the music) These links should be mutually supportive Any apparent disconnect which exists between the two should be taken as a sign that further analytical work should be carried out before a final decision is taken Working capital An accounting term describing the net value of accounts receivable, inventories and pay­ ables When working capital is added to fixed assets, one arrives at capital employed WYMIWYG Stands for ‘What you measure is what you get’ and serves to stress the importance of setting the appropriate targets Bibliography Books Accounts Demystified by Anthony Rice (2008, Pearson Education, Harlow) Now in its fifth edition, this book is suitable for absolute beginners who need more detail on basic accounting than I provide in the third pillar Against the Gods – The Remarkable Story of Risk by Peter Bernstein (1998, John Wiley & Sons, New Jersey) A very enjoyable book, well worth reading by those who want to study the topic of risk in greater detail Competitive Advantage by Michael Porter (2004, Free Press, New York) See page 116 for my comments Competitive Strategy – Techniques for Analysing Industries and Companies by Michael Porter (2004, Free Press, New York) See page 115 for my comments Financial Statement Analysis and Security Valuation by Stephen Penman (2007, McGraw Hill, New York) See page 185 for my comments Global Investment Returns Yearbook by Dimson, Marsh and Staunton all from London Business School (2008, ABN Amro, London) For a widely based and authoritative analysis of long-term returns on investments in debt and equity Manias, Panics and Crashes – A History of Financial Crises by Charles Kindleberger (2005, John Wiley & Sons, New Jersey) You should read this as a warning if you think that crashes and bubbles are unusual! Principles of Corporate Finance by Brealey, Myers and Allen (2008, McGraw Hill, New York) See page 184 for my comments Stocks, Bonds, Bills and Inflation – an Annual Yearbook (Ibbotson Associates, Chicago) I have the 2004 edition which gives US data for 1925–2003 Valuation – Measuring and Managing the Value of Companies by Koller, Goedhart and Wessels, all of McKinsey and Company (2005, John Wiley & Sons, New Jersey) See page 184 for my comments Websites Charities www.gatesfoundation.org 613 614 Bibliography Cost curve data www.minecost.com Credit rating agencies www.moodys.com www.standardandpoors.com Monte Carlo analysis software www.decisioneering.com (for Crystal Ball software) www.palisade.com (for @risk software) Value based management techniques www.valuebasedmanagement.net (for short summaries of hundreds of techniques) Harvard Business School (find Michael Porter’s web page here) www.hbs.edu Journal of Applied Corporate Finance (see spring 2005 edition for the article which I wrote on taking real options beyond the black box) www.morganstanley.com/views/jacf/index.html Judge Business School Cambridge (I lecture to the MBA and Masters of Finance classes) www.jbs.cam.ac.uk London Business School (Risk Measurement Service) www.london.edu McKinsey (register for its quarterly journal here) www.mckinsey.com Index abbreviated financial summary (AFS) basic description, 73–79 Corus example, 96 flexibility (concerns about), 464 overall summary, 564 scaffolding example, 85 wiring diagram, 80 ABCDE valuation B – C effect, 384, 566 basic method, 372–75 link to AFS, 566 Yellow Moon Chemical Company example, 374 absolute value, 191, 254 accounting conventions, 66 how numbers interact, 80 International Financial Reporting Standards, 66 matching (costs to sales), 65 purpose, 63 recognition (sales and costs), 64 results, 106 US GAAP, 66 why this way, 78 accounts payable calculation method, 82 accounts receivable calculation method, 82 acquisitions creating value via, 325 failure to create value, 326 additivity of value basic description, 21 sources of value logic, 266 sunk cost example, 214 airlines (5 forces example), 118, 120 Alliance and Leicester, 346 amortisation basic principles, 66 calculation method, 82 analysis paralysis, 110 anchoring valuation to accounting data, 355 annuity factors, 12, 232 Apple (beta example), 408 615 arbitrage, 34 Arbitrage Pricing Model (APM), 420 assets, current, 68 assets, intangible, 67 assumptions annual averages, 466 appropriate assumptions, 144, 154 best guess of expected value, 430 bias (avoid it), 156 calibration of, 263, 310, 330 checking assumptions, 354 conservative (dice example), 156 controllable and uncontrollable, 104 improving quality of, 155 incremental and absolute, 192 initial example (scaffolding case), 85 most likely, 155 oil price, 104 reasonable assumptions, 331, 430 register of, 156, 195, 254 selling prices (using SoV logic), 310 at cost principle, 68 attitude surveys, 555 balance sheet basic description, 65–69 Corus PLC example, 88 balanced scorecard approach, 112 banks basic description of role, 30 due diligence exercises, 35 mutually owned, 527 beta factor (ß) asset betas and equity betas, 413 basic concept, 166 cost of capital component, 407 Gulf War effect, 407 initial introduction, 50 sector beta, 439 bimodal distributions, 148 birthday treat example, 18 black box approach equity as an option, 419 616 Index black box approach (cont.) Monte Carlo analysis, 240 Black, Fischer, 462 Black Scholes formula, 462, 474 BP (equity return assumptions), 412 Brealey Myers and Allen, 184, 301 bridges accounts to value, 76 profit to cash flow, 69 strategy to value, 265 Bromley Goldfish Sanctuary introduction to, 525 objectives, 528, 538 prism approach example (car park), 539 bubbles, 347, 385, 560 bundling basic concept, 203 unbundling optimisation options, 445 business development costs (ABCDE valuation), 373 business unit strength, 124 buyer power, 120 buying success, 324 call option, 471 capacity reservation fee, 436 Capital Asset Pricing Model (CAPM) basic description, 49 beta factor (ß), 166 WACC formula, 397 capital expenditure (capex) basic description, 70 control system, 106 cargo size (flexibility valuation), 517 cash flow statement, 69 check lists (risk), 172–77 chimera, 561 Claire (project), see also Yellow Moon Chemical Company244 closure costs, 236 coffee and tea facilities example, 553 company as series of projects basic concept, 126–33 overheads & sunk costs (inclusion of), 132 scaffolding example, 126 company valuation basic principles, 342–69 calculated share price, 352 Corus example, 366 dividends or cash flow, 345 liabilities, 366 mean reversion, 346 plan period, 356 plan period asset value, 353 share price calculation, 368 short cut approaches, 369 steps (four), 352 terminal value, 357 Yellow Moon Chemical Company example, 353 competition (nature of), 283, 296 competition authorities, 324 competitor benchmarking, 117, 270, 334 competitor cost of capital, 439 competitor reaction (scaffolding example), 292 components of value, 267 comprehensive risk framework, 175 conservation of value, 53 consolidation (principles thereof), 71 continuous good surprises basic concept, 380 escape from, 551 step changes, 380 control (of capital expenditure), 106 control (re principles of consolidation), 72 copper cost curve example, 296 government control effect, 283 co-product credits, 274 correlations basic concept, 162 equity returns, 162 Monte Carlo analysis, 240 Corus PLC abbreviated financial summary, 96 case study (accounting data into AFS), 88 company valuation example, 366 short cut valuations, 369 synergies with Tata, 371 value of, 97 cost control and risk management, 114 cost curves basic concept, 272–78 copper example, 296 evolution over time, 279 global or national?, 334 shape (importance thereof), 276 sources of value (link to), 272 cost leadership, 122 cost of capital (CoC) assessment (detailed numbers), 412–15 basic concepts, 48–59 best estimate, 415 beta factor (CoC component), 407 buying and selling (importance thereto), 442 calibration against share price, 444 change in CoC example, 440 company-wide or divisional, 421, 449 competitors’ CoC, 439 components (estimates of), 399–412 cost of borrowing (CoC component), 401 cottage industry (avoid), 459 617 Index country risk, 456 country-specific CoC, 420 equity risk premium (CoC component), 409 fudge factors, 449 implied by market prices, 444 inflation effect, 218 initial estimate, 57 market value debt (CoC component), 405 market value equity (CoC component), 406 Modigliani Miller effect, 54, 344 non-value players, 547, 550 optimisation (implications for), 444 project CoC, 415 quantification (as an interest rate), real CoC, 218 risk & reward (implications for), 460 tax rate (CoC component), 404 valuation (implication of changes in CoC), 443 cost of debt (CoD), see interest and cost of capital cost of equity, see CAPM and cost of capital calculation method, 397 when to use, 438 cottage industry (avoid), 459 country entry (flexibility value), 468 country risk (CoC implications), 456 cradle-to-grave approach, 338 credit rating agencies, 36 credit rating definitions, 36 cumulative present value abbreviated financial summary entry, 76 fish diagram, 387 cumulative probability curves, 149 currency effects, see foreign currency effects DCF (discounted cash flow analysis), see economic value model deal or no deal game show, 349 debt advantages over equity, 38 basic concepts, 39 currency (choice thereof), 35 fixed or floating, 31 flexibility, 38 inflation’s impact, 33 leverage illustration, 53 long-term or short-term, 32 modelling issues, 243 recourse and non-recourse, 36 tax relief, 38 valuation of, 30 decision-taking rule, decision trees basic concept, 151 flexibility valuation technique, 509 property auction example, 151 decommissioning costs, 236 Dell computers (sale recognition), 64 depreciation, 66 see also amortisation dice-rolling example (fair market price), 144 differentiation, 122 discount factors basic definition, see also economic value model discount tables, 11 mid-year and end-year, 12, 136 discount rate, see cost of capital discounted payback basic definition, 15 economic indicator (definition of), 256 economic indicator (use as), 17 discounting, see economic value model distributor example (financing activities), 435 diversifiable risk, 176 divestments, 469 dividends basic description, 41 dividends matter?, 45 funds flow (relationship to), 43, 344 modelling issues, 243 setting (use of the marginal dollar), 535 signalling mechanism, 45 valuation of, 342 Yellow Moon Chemical Company example, 246 Do, Learn, Do approach, 110, 531 economic evaluation purpose, 188 standard methodology, 252 economic indicators, 16 definition in standard methodology, 256 introduction to, 16 link to accounting results, 125 sensitivity analysis, 157 economic modelling financed cases, 241 foreign currency effects, 230 hard wiring, 195 inflation, 218 joint ventures, 238 level playing field, 193 model audit, 197 model design, 189 purpose, 193 real cash flow modelling, 219 Russian coffee shop example, 194 spreadsheet layout, 195 standard methodology, 194, 252, 253–57 stock profits, 226 three spreadsheets or one?, 194 working the case, 197 618 Index economic value model basic description, calculating value, 10 flexibility implications thereof, 471 Nobel prize, 395 overview, 396–99 Enron, 106 equity basic concepts, 48 going public, 41 ownership rights, 40 rights issue example, 46 rights issues, 46 share issues, 46 shareholders equity, 68 valuation formula, 43 value of, 41 equity risk premium CoC component, 409 initial estimate, 57 expected value calculations with expected values, 150 correct expected value (U shaped valley), 172 decision-making rule, 428 definition, 146 dice-rolling example, 144 difficulty in assessment, 149, 154 fair market price example, 144 reasonable estimate of, 254 risk monetisation example, 169 experience curve, 279 external risks, 173 failures (incorporation in plans), 154 fair market price, 144 fat-tailed risk, 176 feedback loops, 109 Fence Treatment Inc plan valuation example, 135 understanding performance example, 137 value profile example, 137 finance charges method for exclusion, 84 Yellow Moon Chemical Company example, 248 finance pool availability of capital, 55, 58 basic description, 54 effect of excessive risk, 56 effect of shortage of money, 55 valuation implications, 344 financed cases basic approach, 241 circularity in logic, 242 debt & risk illustration, 51 modelling issues, 242 Yellow Moon Chemical Company case study, 244 financial distress definition, 164 step in treatment of risk/reward, 425 financial options, 471 Financial Statement Analysis and Security Valuation, 185, 330 financing activities Corus example, 91 distrubution cost example, 435 exclusion (method), 74 exclusion from abbreviated financial summary, 74 simple example, 434 step from profit to cash flow, 71 treatment of, 433–39 fish diagram cost of capital change example, 440 introduction to, 390 optimisation & company value example, 451 five forces model, 117 fixed assets basic description, 67 calculation method, 82 fixed costs, 77 flexibility valuation additional costs basic concept (include them), 518 Indian growth example, 519 analogy (valuation method), 518 annual average assumptions, 491 basic concepts, 464–71 Black Scholes, 474, 476, 502, 516 cargo size flexibility, 517 cone of uncertainty, 480 decision trees basic concept, 509 swimming pool cover example, 509 feedstock purchase example, 495 financial options similarities with, 471 first guess (start flexibility assessment with), 487 free flexibility (collect it), 490 growth value basic concept, 500 check list, 484 Indian growth opportunities example, 500 strategy (importance thereof), 500 land value, 470 mapping decisions and uncertainties, 487 me too flexibility, 490, 496 Monte Carlo simulation, 507 more sophisticated assumptions, 491 objectives and boundaries, 485 619 Index oil production/ pipeline size example, 502 organisational capability requirement, 519 partner carry, 470, 508 Plan, Do, Measure, Learn, 520 process, 479–522 reverse engineering, 514 risk monetisation basic concept, 498 pump reliability example, 498 shut down valuation example, 492 single path into the future (not a), 480 steam cracker (feedstock flexibility) example feedstock flexibility valuation, 477 initial summary, 464 reduced demand example, 488 tail (valuation of), 502 toolkit, 479–521 tools (list of), 491 types of flexibility, 467, 483 when flexibility matters, 482 which flexibilities to value, 490 focus (generic strategy), 122 foreign currency effects basic principles, 73 dollar/yen example, 34 economic modelling, 230 flexibility valuation, 516 functional currency, 231, 255 inflation, 229 London Marathon currency example, 73 realised and unrealised, 73 full-cycle economics basic concepts, 207–17 calculation method, 213 interpretation, 215 new product launch (drug example), 209, 216 overheads, 208, 211 overspends, 207 Plan, Do, Measure, Learn, 208 ROCE as an indicator, 212 sanction request example, 208 sources of value implications, 282 standard methodology, definition in, 254 sunk costs, 208, 210 tax (general principle), 211 tax (numerical example), 213 fund managers, 384 funds flow basic definition, 75 difference from cash flow, 242 effect of growth, 131 future value basic definition, value profile over time, 137 garbage in = garbage out (GIGO), 354 Gates (Bill & Melinda Gates Foundation) introduction, 526 limited life of Foundation, 546 Plan, Do, Measure, Learn example, 533 gold bars problem, 236 goodwill, 67 Gordon growth model, 43 grand design example, see property development ­example (grand design) Green Book (HM Treasury), 4, growth benefits from growth, 453 costs, 233 effect on funds flow, 131 growth imperative, 115 impact on ROCE, 129 seductive siren, 384 Gulf War effect, 407 HBOS (equity return assumptions), 411 hurdle rates (effect of), 454 Ibbotson Associates, 400 IBM (beta example), 408 immune system (of organisations), 107 incremental analysis, 191 incremental cash flow basic concept, 20 definition in standard methodology, 253 Indian growth example extra costs effect, 519 flexibility valuation example, 500 inertia, organisational, 107 inflation basic concepts, 218 cost of capital effect, 218 paving slabs example, 220 stock profits, 226 working capital effect, 83, 224 initiatives, 107 insulation example (optimisation of thickness), 444 insurance, 57, 166, 426 interest basic principles, 29 compound interest, fixed or floating, 31 foreign currency effects, 34 inflation’s impact, 33 period of borrowing, 32 pre- or post-tax discounting, 454 simple interest, internal rate of return (IRR) basic definition, 16 620 Index internal rate of return (IRR) (cont.) calculation in birthday treat example, 19 economic indicator (definition of), 256 economic indicator (use as), 17 link to ROCE, 128, 134 not additive, 21 International Financial Reporting Standards, 66 inventories basic description, 68 calculation method, 83 investing activities (step from profit to cash flow), 70 investment efficiency basic concept, 17 economic indicator, 256 investment grade credit rating, 38 iron ore, cargo flexibility example, 517 Jake (student), joint ventures modelling issues, 237 Yellow Moon Chemical Company example, 305 junk bonds, 38 killer reason, 544 Koller, Goedhart and Wessels, 184 KPMG, 405 laggards, 276 land value, 236, 470 least-cost strategy, 122, 318 level playing field basic concept, 193 suggested standard methodology, 253–57 why required, 253 liabilities, current, 68 liabilities, non-current, 68 linear relationships, 150 liquidity assumption of, 476 projects compared with shares, 399 Lloyds TSB (equity return assumptions), 412 loans, see debt London Business School Global Investment Returns yearbook, 410 London Marathon example (currency effect), 73 long-term plan, 103 market attractiveness, 124 market price, willing buyers and sellers, 144 market survey (valuation thereof), 510 Mars (man from), 335 McKinsey/GE matrix basic concept, 123 sources of value (link to), 263, 271 me too basic concept, 262, 275–81 don’t be me too, 336 evolution over time, 264, 299 flexibility valuation, 490 government control, 283 return (choice of), 281, 298 return (CoC change example), 441 start-up companies, 532 value map, 319 mean reversion, 346 Merton Robert C, 462 Microsoft, 44, 470 minority interests, 68, 93 Modigliani Miller (MM) implications for valuation, 344 proposition (introduction to), 53 monetisation of risk, 168–72 Monitor (NHS regulator), 548 Monte Carlo analysis basic concept, 239 company valuation, 355 drawbacks, 240 expected value calculation, 428 flexibility valuation technique, 507 Moody’s, 36 nascent industry argument, 485 net book value, 66 net present value (NPV) basic definition, 14 calculation via expected value assumptions, 151 economic indicator, 256 incremental and absolute, 191 new entrants (threat of), 120 Nobel prize 199 (Markowitz et al), 395 1997 (Merton & Scholes), 462 non linearity, 240 non-financial items (valuation of), 553 non-value players availability of finance, 529, 544 basic concept, 523 coffee & tea facilities example, 553 continuous improvement (acceptability of), 550 financing constraints, 537 objectives, 534, 537 purpose, 528 risk aversion, 548 scorecard (against value players), 559 similarities with value players, 527 staff turnover reduction example, 553 timing (of finance availability), 545 NOPAT, 78 Norman (rich Uncle), 5, 191 Norman’s birthday treat example, 18, 191 621 Index off balance sheet, 72 oil field development assessed against nothing, 195 government control effect, 283 platform example (flexibility value), 486 price assumptions (in a plan), 104 price assumptions (ten possibilities), 144 production uncertainty (pipeline size example), 502 shutdown flexibility, 517 operating activities (step from profit to cash flow), 70 operating leverage, 433 optimisation basic principles, 198–203 case study (implications of optimisation), 447 case study (selecting optimisation studies), 201 CoC (importance of), 444 difficulty thereof, 199 fish diagram project example, 451 organisation and management alignment with sources of value, 264 basic concepts, 102 corporate strategy, 100 flexibility value implications, 519 outsourcing, 469 overarching risks, 425 overheads ABCDE valuation, implications thereof, 373 control of, 114 corporate, 114 inclusion in NPV analysis, 132 scaffolding example, 132 ownership (re principles of consolidation), 72 P10 P90 range, see sensitivity analysis P10 P90 tail valuation example, 505 partner carry, 470 paving slabs example inflation (inclusion of), 220 inflation, tax and working capital example, 224 initial case study, 24–26 Penman Stephen H, 185 performance (understanding thereof) basic concepts, 376 Fence Treatment Inc example, 137 performance reports, 105 perpetuity valuation formula, 42–43, 135, 237, 248, 357 pharmaceuticals five forces example, 118, 121 pipeline size example (flexibility valuation), 502 Plan, Do, Measure, Learn basic concept, 109 flexibility valuation implications, 520 full-cycle economics, 208 Gates Foundation example, 533 improving assumptions, 155 risk analysis, 174 sources of value analysis, 312 sustaining investment, 206 planning main components, 100–108 techniques, 115 plans annual plan, 105 controllable and uncontrollable variables, 104 feedback loops, 109 Fence Treatment Inc plan valuation example, 135 flow through, 104 long-term plan (LTP), 103 plan period, 356 planning cycle, 108 timetable, 104 top down & bottom up, 110 valuation, 134 Porter (Professor Michael) Competitive Advantage, 116 competitive advantage technique, 121, 264 Competitive Strategy (book), 115 five forces model, 117, 174, 264 McKinsey/GE matrix, 123 supplier power, 119 value chain model, 116, 174, 337 portfolio diversification ability to take risk, 164 basic concept, 160 coin-tossing example, 160 correlations (effect of), 162 transaction costs (effect of), 165 portfolio screening tool, 124 prepayments, 68, 84 present value (basic definition), price war, 322 Principles of Corporate Finance, 184, 208, 217, 384 prism approach, 540 probability distributions, 147 product life cycle, 279 profit basic concepts, 65 cash flow (link to), 69 project evaluation (real life), 16 project life basic concepts, 134, 232 company rules, 234 consistent assumptions, 233 cost assumptions (consistency with), 233 property development example (grand design) debt & risk illustration, 50 initial example, 24 property plant & equipment, 67 provisions, 68 put option, 471 622 Index real options, see flexibility valuation real return, link to nominal return, 33 receivables, trade, 68 redundancy costs, 236 residual value basic concept, 234 recommended methodology, 235 returns (seductive siren), 384 reverse engineering, 514, 556 Rhett Butler, 312 rights issue, 46 risk, see also assumptions and expected values archetypes, 448 brainstorm approach, 175 capacity, 57, 146, 164 capacity (YMCC example), 252 check lists, 172–77 company check lists, 174 comprehensive risk framework, 175 defining risk, 142 definition by Monitor, 549 external, 174 fat-tailed or thin-tailed, 176 financial, 173 impact x probability, 169 internal & external, 173 managing risk, 170 mitigation, 170 monetisation, 168–72 operational, 173 optimisation in the face of risk, 170 overarching, 425 personal capacity to take risk, 349 probability distributions, 147 risk capacity, 164 sensitivities, 448 success values, 153 trade-off with reward, 48, 166 types of risk (3 in all), 175 U-shaped valley, 171 uncertainty, 348 risk-free rate basic concept, 50 CoC component, 400 real, 401 risk/reward trade-off Capital Asset Pricing Model, definition of risk, 166 Capital Asset Pricing Model, introduction to, 49 four steps, 423 overall approach, 423–33 what the CoC tells us, 460 ROCE (or ROACE) basic concept, 78 bridge between accounts and value, 133, 269 company as series of projects example, 128 inflation effect example, 226 link to IRR, 128 Russian coffee shop example, 194 safety margin (over zero NPV), 388 scaffolding example company as series of projects example, 126 components of value analysis, 267 initial case study, 84 sensitivity chart example, 159 sources of value analysis, 288 Scholes Myron S, 462 scorecard (value against non-value players), 559 scrap value, 236 search costs, see full-cycle economics sector attractiveness, 101, 294 sector attractiveness and competitive position, 271 security (of borrowing), 35 security market line, 168 seductive sirens, 384 sensitivity analysis basic description, 17, 156 choice of, 157 definition in standard methodology, 257 NPV or IRR, 157 P10 P90 range (type 1), 158 presentation of, 157 scaffolding example chart, 159 types of sensitivity (1 or 3), 158 zero NPV case (type 2), 158 share of growth analysis, 323 share price, see company valuation shareholder value continuous good surprises, 380 rules of the game, 379 shareholders’ perspective of risk, 167 treadmill effect, 380, 551 shareholders’ plan, 379 shares, see equity Sharpe William Capital Asset Pricing Model, 49 Nobel prize, 395 skew, 148, 176 small companies, 165 sources of value acquisitions (how to create value), 325 additivity of value, 266 alone (don’t go out alone), 335 application design stage, 309 detailed design stage, 293 getting started, 315 implementation map, 292 623 Index implementation stage, 294, 313 initial case study (scaffolding), 288 operation stage, 294, 314 options identification stage, 293, 303 standard categories of SoV, 300 strategy stage, 293 basic concept, 260 brand, 278, 328 buying success, 324 calibration of assumptions, 263, 310, 330 competition (nature of), 287 competitor benchmarking data, 270 components of value, 267 cost curves, 272–78 diagram (introduction to), 261 full-cycle and point-forward economics, 281 government controls, 283, 331 how to apply, 288 how to win, 318 individuals, 338, 340 introduction, 258 leveraging sources of value, 264 look downwards, 321 McKinsey/GE matrix, 263 non-value players, 534 overall summary, 562 project life cycle, 338 quantification, 269, 311 regulation, 331 regulators, 286 search costs, 327 senior management support, 316 so what – implications of SoV, 317 sunk costs, 282 what is the SoV technique, 259 why the technique works, 265 Yellow Moon Chemical Company example, 304 sports shirts example initial work assignment, 178 sources of value analysis, 338 staff turnover reduction example, 553 stage gate processes basic concept, 113 depot example, 113 flexibility valuation (aid to), 487 flexibility valuation link, 480 optimisation of projects, 199, 200 Sources of Value implementation map, 292 Standard & Poor’s, 36, 165 Standard & Poor’s credit rating scale, 36 standard deviation (portfolio effect), 161 standard methodology, see economic modelling basic principles, 252 suggested wording, 253–57 startup companies, 379, 531 step changes, 380 steps (from profit to cash flow), 70 stock profits, 226 stocks, see inventories Stocks, Bonds, Bills and Inflation, 400 strategic investments, 469 strategy basic concepts, 100 business strategy, 100 change in, 215 changing strategy, 103 corporate strategy, 100 leverage (maximum point of), 567 strategy to actuals, 108 strengths and weaknesses, 101 stuck in the middle, 122 substitutes (threat of), 120 success value basic concept, 153 company valuation, 355 flexibility valuation, 487 planning for success, 153 property development example, 154 swimming example, 153 sum of all years technique, see company as series of projects sunk costs, see also full-cycle economics basic concept, 132 sources of value, 312 supplier power, 119 sustaining investment basic concept, 203 control of, 205 justification, 204 legislative changes, 206 valuation (impact on), 355 swimming example (success value), 153 swimming pool cover example decision tree flexibility valuation method, 509 reverse engineering flexibility valuation method, 515 T bill basic description, 29 rate over time, 400 risk-free rate, 400 tail distribution (tail thereof), 176 industry cost curve (tail thereof), 276 valuation of, 502 target setting appropriate targets, 112 behavioural impact, 111 624 Index Tata Steel (bid for Corus) introduction to, 88 synergies, 371 valuation of Corus, 370 tax calculation method, 80 inflation (effect of), 224 pre- or post-tax CoC, 454 rates over time, 405 relief on interest, 84, 94 residual value effect, 236 terminal value basic concept, 135, 235 Fence Treatment Inc example, 136 perpetuity valuation equation, 237 terminal value methods book value method, 364 funds flow to perpetuity method, 357 growth-adjusted profit method, 358 life of asset method, 363 liquidation method, 365 list of methods, 357 overview-adjusted profit method, 359 specified company life method, 363 sustainable return on capital method, 360 trading multiple method, 364 two-stage growth to perpetuity method, 361 time value of money, see cost of capital top down and bottom up, 110 total assets, 68 transaction costs, 146, 165, 476 treadmill (of stock exchange performance), 380 type 1, or sensitivities, 158 U-shaped valley, 171 unbundling, 445 uncertain uncertainty, 350 uncertainty, 142, 348 understanding accounts, see accounting US GAAP, 66 Valuation – Measuring and Managing the Value of Companies, 184, 235, 330 value (concept thereof), see economic value model value creation basic concept, 139 continuous good surprises, 379 value destruction, 383 value drivers, 383 value growth, see value profile value map, 301 value profile basic concept, 14, 137 Fence Treatment Inc example, 137 growth (of value over time), 138 simple example (two year project), 377 value proxies, 383 value return basic concept, 137 plans return the cost of capital, 377 variable costs basic concept, 77 cost curves (component thereof), 274 negative variable costs, 274 sector attractiveness (impact thereon), 291 vision, 108 volatility basic concept, 161 option value, effect on, 476 WACC (weighted average cost of capital), see also cost of capital basic description, 50 formula, 397 winner’s curse, 325 words and music basic concept, 125 CoC change example, 442 consistency between IRR and ROCE, 129 Sources of Value test of assumptions, 309 work in progress, 68 working capital basic description, 70 calculation method, 83 financing effects, 437 recovery (via residual value), 236 standard methodology convention, 255 target setting, 111 World Mine Cost Data Exchange Inc, 296 WYMIWYG, 110, 134, 383 Yellow Moon Chemical Company ABCDE valuation example, 374 initial case study, 244 sources of value example, 304 valuation example, 353 yield graph, 402 zero NPV decision rule, 14 type sensitivities, 158 why invest in zero NPV projects, 453