FBE 529 Financial Analysis & Valuation

Financial Analysis & Valuation

 Introduction and Course Overview
Scott Abrams
Spring 2020

FBE 529 – Scott Abrams – Spring 2020 FBE 529 – Scott Abrams – Spring 2020
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Course Introduction Learning Objectives & Topics

Financial Analysis and Performance Measurement
 Objectives  What do the numbers mean? We will discuss tools for analyzing
 Materials company strategy and financial performance.
 Grading
 Expectations and Success Factors Core Valuation Techniques and Financial Analysis
 Course Outline  Perform valuations using DCF, market multiples and transaction
based approaches for:
 Fundamental research
 Strategic analysis
 IPOs, mergers and restructurings

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 Learning Objectives & Topics Learning Objectives & Topics
Assessing a firm’s business and competitive strategy Have an understanding of other valuation issues and
 Is it creating value for shareholders? special situations
 High growth and private companies
 Highly leveraged companies and LBO transactions
Effectively communicate a valuation perspective and
 Financial Distress
business strategy
 Valuation in a Declining Industry
 Case analyses
 Group project
Apply valuation in a global context
 International markets, economic, and social and cultural
issues

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Course Materials Course Materials

 Textbook  Textbook:
 Cases  Valuation: Measuring and
Managing the Value of
 Wall Street Journal Companies, 6/E (University
 Calculator Edition) ISBN: 9781119556275
 Blackboard  You may purchase on Amazon
(or another source); the 6th
edition (University edition) is
recommended
 You can also access the e-book
for free from our libary

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 Course Materials Grading
Required Cases: Our course pack (CP) can be purchased online
through the HBS link: https://hbsp.harvard.edu/import/696196  Class Participation 5%
 HBS Notes  Individual Case Assignment 5%
Solving the Puzzle of the Cash Flow Statement (optional)

 Group Case Analyses 20%
 Corporate Valuation and Market Multiples
 Primer on Multiples Valuation and Its Use in Private Equity Industry  Team Valuation Project 17.5%
 Valuation of the Early Stage Company  Midterm Exam 25%
 Valuation of Late-Stage Companies and Buyouts  Final Exam 27.5%
 HBS Cases
 Financial Policy at Apple, 2013 (A)
 The Valuation and Financing of Lady M Confections
 Snap Inc.’s IPO (A)
 Spyder Active Sports 2004
 H.J. Heinz M&A
 Buffett’s Bid for Media General’s Newspapers
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Expectations & Success Factors Course Outline

Week Topic
 Understand the materials Principles of Value Creation
Part I  Big Picture
 Read course material before class meetings (Week 1)

 Ask questions Part II  Financial Statement Analysis Financial Analysis &

(Weeks 2-5)  Ratio Analysis Performance Evaluation
 Actively participate  Cash Flow Analysis Group Cases
 Work on problems before and after class Part III  DCF Valuation Building a Tool-kit and
 Work with other students and take advantage of my office (Weeks 5-15)  Relative Valuation
IPO Valuation
Application
hours


 APV Method
Group Cases &
Venture Capital and Private Equity
 Keep abreast of current financial and economic events 

 Mergers and Acquisitions

Midterm

 Apply what you have learned  Leveraged Buyouts (LBOs)

 Valuation in a Declining Industry
 Financial Distress and Restructurings
 Valuation of Financial Services Firms
Part IV  Group Valuation Project Putting it all Together
(Weeks 15-16) Final Exam

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 Why do we Perform Valuations? Major Investment Decisions
 When a firm is evaluating either an internally generated investment We will discuss how firms evaluate investments and grow and expand
project or an external acquisition through:
 When a firm is considering share issuances, share repurchases and
restructurings  Project valuation: firms acquire productive capacity by
 Acquisition of a company (AT&T acquiring Time Warner) assembling necessary assets
 Valuation of T  Enterprise valuation: acquisitions of entire businesses -
 Valuation of TWX acquiring the productive assets of an existing firm
 Fundamental Analysis – an analyst or an investor attempting to  Common valuation tools and underlying principles can be
determine if a security is under or overvalued?
used for both types of analysis
 Strategic Analysis
Knowing how to value assets or businesses is essential for managers who
want to formulate value creating business plans and strategies, to value firms
or business units, to evaluate restructuring options, and to make sound
economic decisions
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Transactions Asset and Financial Restructuring

 Asset restructuring
 Merger and acquisition transactions  Asset sales (selling off assets)
 Leveraged buy-out transactions  Divestitures (selling off a division or unit)
 Going public  Spinoffs (distribute shares of a subsidiary to existing shareholders
on a pro-rata basis)
 IPO for privately held corporation
 Subsidiary IPO (equity carve-out)
 IPO of a subsidiary
 Liquidations (extreme form of sell-off)
 Privatization of government entity
 Financial restructuring
 Debt recapitalization (refinancing and paying out a one time
dividend or repurchasing stock with the proceeds)
 Default workouts
 Leveraged buyout

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 Strategic Analysis
Spinoff/Subsidiary IPO Examples (Value-Based Management)

 Understand the effect of alternative strategies on value

through a DCF model
 Three overarching questions:
 How does (or did) the strategic action affect the magnitude of
the free cash flows?
 How does (or did) the strategic action affect the timing of the
free cash flows?
 How does (or did) the strategic action affect the underlying
risk of the cash flows?

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Fundamental Analysis for How much is one share of AAPL

Portfolio Selection worth?
 Identify over and undervalued stocks
 Do such stocks exist?
 Do you have superior ability/information relative to the
market?
 Will the market ultimately recognize your view and re-price
the security appropriately?

FBE 529 – Scott Abrams – Spring 2020 Source: Bloomberg, January 13, 2020 FBE 529 – Scott Abrams – Spring 2020
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 How much is one share of AAPL
worth? What is Value?
 Alternative terms used when describing the value of a
company are:
 Fair market value
 Market value
 Fair value
 Book Value
 Intrinsic Value
 Fundamental Value

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The objective of performing a

Intrinsic Value vs. Market Value
 Intrinsic value is the ‘actual worth’ of an investment or
asset justified by information about its future cash flows
 it is the “true” value according to a model
 Market value is the price determined by buyers or sellers
on an open market
 it is the consensus value of all market participants
valuation is to…
 Assess the true or intrinsic value of an asset.
 Our problem is that intrinsic value is unobservable.
 To arrive at intrinsic value, we have to make estimates about
the future
 Since the future is unknowable, we can only estimate intrinsic
value

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 Example: Market vs. Intrinsic
Value Buy / Sell Recommendation
 Value Investor  Example:
 Looks to invest in a security that is trading at a discount to  Research Conclusion:
its intrinsic value and to sell a security that is trading above  Current Stock Price: $80
that value  Valuation (based on DCF): $80
 Growth Investor  Outlook: The near to mid-term outlook for the
company is excellent. It should see revenue and earnings
 Looks to invest in a company with above average growth well above the economic growth, and revenue and
prospects for growth in the future earnings growth should outpace the industry growth as
well
 Recommendation for a Value Manager:
 Recommendation for a Growth Manager:

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What Matters in a Valuation? What Matters in a Valuation?

 Remember the “Story” in valuing assets:
 The market’s expectations for future cash flows (not
accounting earnings)
 The distribution of those cash flows over time
 The uncertainty of those cash flows (how risky are the cash
flows  discount rate)
 The presence of growth options or opportunities

What really matters are the drivers of cash flow/value: the

rate at which a company can grow and its return on
invested capital (relative to the cost of capital)

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 Is the Market Overvalued? What Factors Impact the Market?
The average long‐term trailing 
P/E ratio has been 16‐17x. The 
disconnect between price and 
TTM earnings in 2009 was so 
extreme that the P/E ratio was 
in the triple digits.

In 1999, a few months before 
the top of the Tech Bubble, 
the conventional P/E ratio hit 
34. It peaked close to 47 two 
years after the market topped 
out.

FBE 529 – Scott Abrams – Spring 2020 Source: advisorperspectives.com, January 2020 FBE 529 – Scott Abrams – Spring 2020
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What is the Shiller PE or CAPE

What is the P/E10? Ratio?
 The regular P/E uses the ratio of the S&P 500 index over the
TTM earnings of the S&P 500 companies.  In recent years, Yale professor and Nobel laureate Robert
Shiller, the author of Irrational Exuberance, has popularized the
 During economic expansions, companies have high profit margins
and earnings. The P/E ratio may become artificially low due to concept to a wider audience of investors
higher earnings; during recessions, profit margins and earnings  Shiller selected the 10-year average of “real” (inflation-adjusted)
tend to be low. earnings as the denominator and refers to this ratio as the
‘Cyclically Adjusted Price Earnings Ratio’ or ‘CAPE’
 Legendary economist and value investor Benjamin Graham
collaborated with David Dodd to devise a more accurate way to
calculate the value of the market which is discussed in their
1934 classic Security Analysis
 They attributed the illogical P/E ratios to temporary and sometimes
extreme fluctuation in the economic cycle. Their solution was to
divide price by a multi-year average of earnings – and suggested 5,
7, or 10 years.
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 What Factors Impact the Market? Markets & Fundamentals
The historic P/E10 average is 
16.8. After dropping to 13.3 in 
March 2009, the ratio 
rebounded to a high of 23.5 in 
February 2011 and then 
hovered in the 20‐to‐21 
range. It began rising again in 
late 2013 and hit an interim 
high of 27.0 in August 2015. It 
is currently at 30.0.
The P/E10 closely tracks the 
real (inflation‐adjusted) price 
of the S&P Composite. The 
detrended correlation 
between the two since 1881 is 
0.9977.
The chart includes horizontal 
banks to divide the monthly 
valuations into quintiles – five 
groups, each with 20% of the 
total. Ratios in the top 20% 
suggest a highly overvalued 
market, the bottom 20% a 
highly undervalued market.
Source: advisorperspectives.com, January 2020 FBE 529 – Scott Abrams – Spring 2020 FBE 529 – Scott Abrams – Spring 2020
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Markets & Fundamentals The Behavioral Challenge

 Where are we now (P/E ratios)?
 Markets values may deviate from intrinsic values in the
 AAPL ~ 26.7x following situations:
 FB ~ 35.5x We need to consider company and
 When individual investors behave irrationally
 GM ~ 5.7x sector ROE and growth prospects,
economic fundamentals such as GDP  When systematic patterns of irrational behavior emerge
 XOM ~ 20.3x growth rates, etc. among investors
 NKE ~ 35.7x  When there are limits to arbitrage
 CRM ~ 205.3x; 64.5 forward P/E  The field of behavioral finance studies the ‘psychology’ of the
 AMZN ~ 83.8x; 79.4 forward P/E market and how market valuations can deviate from intrinsic,
 TSLA ~ nm; 84.5x forward P/E fundamental values.
 SP500 ~ 24.6x
Emotions can lead to mispricing in the market.
Source: Capital IQ, January 13, 2020

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 Is the Stock Market Rational? Do
Fundamentals Drive the Stock Market?
 The market can lose touch with economic fundamentals in
the short term.
 In the long term, evidence shows that individual stocks and
the market as a whole track ROIC and growth.
 Value is driven by returns on capital and growth
 The US and UK stock markets have been fairly priced and
have oscillated around their intrinsic P/E ratios
 Deviations from intrinsic value occurred in the late 1970s and
the 1990s. However, the stock market corrected itself within
3 +/- years to intrinsic levels.
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Stock Market has been a roller
coaster over the past 20 years
 In the second half of the 1990s, the S&P 500 more than
tripled in value to an all-time high of almost 1500
 Previous unknowns such as Amazon and AOL became stock
market superstars
 The market then crashed, and many lesser stars flickered out
 After 2003, stocks recovered at a stunning pace, and by
2007 the S&P 500 had regained its all-time high
 The market crashed again in 2008 as a result of the credit
crisis, losing around 50% of its value in the course of a few
months
 Can long-held valuation theories explain such dramatic
swings in share prices?
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Explaining Market Returns over Stock Markets Track Economic

Two Centuries Fundamentals

Source: McKinsey analysis Source: McKinsey analysis

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 Markets and Fundamentals:
Impact of Largest Stocks on Overall Market Markets & Fundamentals:
Valuation Stock Markets Track Economic Fundamentals
 McKinsey & Co. estimated the intrinsic P/E ratios for the US and UK stock
markets and then computed them with actual values  In spite of recent turmoil in US and European stock markets,
there is overwhelming evidence that markets are reflecting
economic fundamentals.
 Valuation levels for those as a whole over the past 45 years
and equity returns over the past 200 years are generally
consistent with the long-term performance in the real
economy in terms of growth, inflation, and corporate returns
on capital.
 Valuation for individual companies is similarly driven by
The late 1970s and late 1990s produced significant deviations from intrinsic valuations. In the late 1970s, when investors were
returns on capital and growth.
obsessed with high short-term inflation rates, the market was probably undervalued; long-term real GDP growth and returns on
equity indicate that it shouldn't have bottomed out at P/E levels of around 7. The other well-known deviation occurred in the late
1990s, when the market reached a P/E ratio of around 30—a level that couldn't be justified by 3 percent long-term real GDP
growth or by 13 percent returns on book equity.

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Source: Compustat, McKinsey analysis 40 41

Markets and Fundamentals Markets and Fundamentals

Implications for Corporate Managers Taking Advantage of Market Deviations:
 Managers should always utilize the discounted cash flow  Issuing additional shares of stock when the market attaches too
analysis approach for strategic decisions. high a value of the company’s shares relative to their intrinsic
 Market deviations make it even more important for executives of value
a company to understand the intrinsic value of its shares. This  Repurchasing shares when the market underprices them
knowledge allows it to exploit any deviations, if any when they relative to their intrinsic value
occur, to time the implementation of strategic decisions more  Paying for acquisitions with stock instead of cash when the
successfully. market overvalues the shares relative to their intrinsic value
 Selling off divisions at times when market multiples are higher
than can be justified by underlying fundamentals

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 Conservation of Value Summary
 Anything that doesn’t increase cash flows doesn’t create value
 Conservation of Value Principle: Anything that does not
 M&M: The value of a company should not be affected by increase cash flows does not create value.
changing the capital structure of the firm unless the overall cash  The stock market is smarter than you think: dramatic swings
flows generated by the company also change in the share prices have led some finance practitioners to
suggest that long-held valuation theories have become
irrelevant.
 There is compelling evidence that valuation levels reflect
underlying fundamental performance in terms of return on
capital and growth.
 Focus on cash flows and solid fundamentals.

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Facebook Inc. Facebook Inc.

$500

$23,000
Value of Facebook  Free Cash Flows (May 2012) Value of Facebook  Free Cash Flows (May 2012)
‐ Market  Capitalization = $81.3 Bil; Price = $38 ‐ Market  Capitalization = $81.3 Bil; Price = $38
$400 ‐ 2011 FCF = $470 mil  $20,000 ‐ 2011 FCF = $470 mil 
‐ Discount  rate = 10% ‐ Discount  rate = 10%
‐ Perpetual  growth  rate beginning  in 2032 = 3% ‐ Perpetual  growth  rate beginning  in 2032 = 3%
‐ Required annual  growth  rate for 20 years = ???% $17,000 ‐ Required annual  growth  rate for 20 years = 21.5%
$300

What does Facebook need to $14,000

What does Facebook need to
achieve to justify its value in achieve to justify its value in
$200 May 2012? $11,000 May 2012?

$100
What happened to its value? $8,000 What happened to its value?
Facebook Free Cash Flows in $ millions
$5,000

$0
2007

2008

2009

2010

2011

$2,000

‐$100 ‐$1,000
2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

2026

2027

2028

2029

2030

2031

2032
Facebook Free Cash Flows in $ millions

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 Facebook Inc. Facebook: May – Aug 2012
 $25,000

Value of Facebook Free Cash Flows (May 2012):
‐ Market  Capitalization = $81.3 Bil; Price = $38 38.23
‐ 2011 FCF = $470 mil 
 $20,000
‐ Discount  rate = 10%
‐ Perpetual  growth rate beginning  in 2032 = 3%
‐ Required annual  growth rate for 20 years = 21.5%

 $15,000 Value of Facebook  Free Cash Flows (August 2012):

‐ Market  Capitalization = $41.7 Bil; Price = $19
‐ 2011 FCF = $470 mil 
‐ Discount  rate = 10%
‐ Perpetual  growth  rate beginning in 2032 = 3% 18.06
 $10,000 ‐ Required annual  growth  rate for 20 years = 16.6%

 $5,000

Facebook Free Cash Flows

 $0 Source: Bloomberg

2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032

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Facebook: May 2012 – August 2019 Rise of the Unicorns

217.50 221.91
217.50

177.75

38.23
38.23

Source: Bloomberg, January 13, 2020 Source: New York Times, April 1, 2015
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Rise of the Unicorns …and the fall of the Unicorns?

SNAP

ARPN

Source: New York Times, April 1, 2015 Source: Bloomberg, August 23, 2019
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What are the Different Approaches

IPOs in 2019 to Performing a Valuation Analysis?
 Intrinsic valuation – the value of an asset is a function of its
fundamentals (cash flow, growth rates, risk).
 Relative/comparables valuation – the value of an asset is
estimated upon what investors are paying for similar assets.
We can use market multiples of comparable firms or multiples
of precedent transactions to perform this approach
 Asset based valuation
 Book value
 Liquidation value models
 LBO Model valuation
The valuation should consider operations, lifecycle stage, size, risk, and
growth
Source: WSJ FBE 529 – Scott Abrams – Spring 2020 FBE 529 – Scott Abrams – Spring 2020
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 Overview of the valuation process Financial Analysis & Valuation
1. Understanding the business model
2. Evaluating the historical financial performance of the firm
3. Selecting the valuation method
4. Applying the valuation model  Foundations of Value
5. Consider other valuation methods and triangulating results

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Foundations of Value NFLX: 10 YR Price Chart

 Market value balance sheet
 Value creation overview
 Value investing and fundamental analysis
 Relationship between Growth, ROIC, and Cash Flow
 Is growth always good?

FBE 529 – Scott Abrams – Spring 2020 Source: Bloomberg FBE 529 – Scott Abrams – Spring 2020
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 What is a Market Value Balance Equity Valuation: The Dividend
Sheet? Discount Model
DCF Methods: Equity Valuation vs. Firm Valuation  Stock ownership produces cash flows from
 Dividends (and other payouts) from the firm
Hollywood Studios, Inc.
Balance Sheet  Capital gains (or losses) from trading in the stock markets
Market value vs. Book value  Capital gains (or losses) depend on the estimates of the future
capacity to pay dividends
Assets Liabilities and Shareholder Equity
Book Market Book Market
A source of a firm’s intrinsic value is its capacity to pay future dividends.
Current assets 400 600 Long-term debt 500 500
Fixed Assets in Place 1,800 3,000 Shareholder's equity 1,700 8,100  Valuation of Different Types of Dividend Paying Stocks
Growth Assets - 5,000
Total 2,200 8,600 Total 2,200 8,600 1. Zero Growth
2. Constant Growth
3. Differential Growth 𝑻
𝑫𝒊𝒗𝒕
𝑷𝟎 𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕𝒆𝒅 𝒆𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒇𝒖𝒕𝒖𝒓𝒆 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔 𝒕
𝟏 𝑹
𝒕 𝟏
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Zero Growth (Constant Dividend):

An Example Constant Growth: An Example
 If dividends are expected at regular intervals forever, then  Suppose Abrams, Inc., just paid a dividend of $0.50 per
this is a perpetuity and the present value of expected share. It is expected to increase its dividend by 2% per
future dividends can be found using the perpetuity year. If the market requires a return of 15% on assets of
formula this risk, how much should the stock be selling for?
 P0 = D / R
 Suppose the stock of Abrams Inc. is expected to pay a
$0.50 dividend every quarter and the required return is
10% with quarterly compounding. What is the price?
 P0 =

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 Differential Growth: An Example
Differential Growth: An Example (Cont’d)
 Suppose Abrams Inc. is expected to increase dividends  Compute the dividends until growth levels off
by 20% in one year and by 15% in two years. After that,  D1 =
dividends will increase at a rate of 5% per year  D2 =
indefinitely. If the last dividend was $1 and the required
 D3 =
return is 20%, what is the price of the stock?
 Find the expected future price
 Remember that we have to find the PV of all expected
 P2 =
future dividends.
 Find the present value of the expected future cash
flows
 P0 =

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Valuing Firms with Growth

Where does g come from? Opportunities: An Example
 The value of a firm depends upon its growth rate, g, and
its discount rate, R.  Suppose a firm forecasts to pay a $8.33 dividend next
 Where does g come from? year which represents 100% of its earnings per share
g = Retention ratio × Return on retained earnings (ROE) (EPS). Investors require a return of 15%. What is the
intrinsic value of the stock?
 Given its current level of profitability and dividend policy, the  P0 =
sustainable growth rate is the maximum rate that a firm can  P/E =
grow without restoring to additional external financing while
maintaining a constant D/E ratio
 The starting point of the analysis of profitability is with the
ROE, the rate of return the firm has provided to its common
shareholders
 If a firm elects to pay a lower dividend and reinvest the
funds, the stock price may increase because future
dividends may be higher
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 Valuing Firms with Growth Valuing Firms with Growth
Opportunities: An Example (Cont’d) Opportunities: An Example (Cont’d)
 What if the company decided to plowback and invest in
 Now suppose that the firm decides to plow back or growth, but due to increased competition or other
reinvest 40% of its earnings at the firm’s current ROE of circumstances, such as a poor macroeconomic environment,
25%. What is the intrinsic value of the stock after the the company’s ROE falls to 13%?
reinvestment decision?  SGR =
 SGR =  Dividend =
 Dividend =  P0 =
 P0 =  P/E =
 P/E =

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Valuing Firms with Growth

Opportunities ~ Example Blockbuster Inc.
 In summary:
 Zero growth firm ~ 7x P/E
 Growing firm with a 25% ROE ~ 12x P/E
 Growing firm with a reduced (13%) ROE ~ 6x P/E

 This example shows that a company’s justified P/E valuation

multiple is driven both by its expected growth and its return
on equity
 In the increased state competition state of the economy, the
company destroyed shareholder value by choosing to invest
at an ROE that is lower than its cost of capital

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 Foundations of Value ROE and the Du Pont Identity
NI
ROE
 Is growth always good? 𝐸𝑞𝑢𝑖𝑡𝑦
 Is it generally a good idea for a company to grow its ROE
business?

Profit Total Equity

Margin Asset Turnover Multiplier

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

𝑅𝑂𝐸
𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦

𝑃𝑀 𝑇𝐴𝑇 𝐸𝑀

Investors use the information in a company’s financial

statements to perform many types of analysis. One example is
to analyze a company’s ROE

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Various DCF Models Is Growth Always Good?

74
Input Dividend FCFE (Potential FCFF (firm) It depends on the return on capital.
Discount Model dividend) valuation model
 Consider these two companies. Both firms earned $100m in year 1 and
discount model
increased their revenues and earnings at 5% per year, so their projected
Cash flow Dividend Potential FCFF = Cash earnings are identical.
dividends = FCFE flows before debt
= Cash flows after payments but after  Value Inc. invests 25% of its profit; Volume Inc.’s investment rate is 50%
$ million Value Inc.
taxes, reinvestment
reinvestment needs and taxes. Year 1 Year 2 Year 3 Year 4 Year 5
needs and debt Revenue $      1,000 $      1,050 $      1,103 $      1,158 $      1,216
cash flows Earnings             100             105             110             116             122
Investment (25%)               25               26               28               29               31
Expected growth In equity income In equity income In operating Cash Flow $            75 $            79 $            83 $            87 $            92
and dividends and FCFE income and FCFF Volume Inc.
Discount rate Cost of equity Cost of equity WACC Year 1 Year 2 Year 3 Year 4 Year 5
Revenue $      1,000 $      1,050 $      1,103 $      1,158 $      1,216
Steady state When dividends When FCFE grow When FCFF grow
Earnings             100             105             110             116             122
grow at constant at constant rate at constant rate
Investment (50%)               50               53               55               58               61
rate forever forever forever Cash Flow $            50 $            53 $            55 $            58 $            61

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 What is ROIC? What is ROIC?

𝑁𝑂𝑃𝐿𝐴𝑇
𝑅𝑂𝐼𝐶
𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

 NOPLAT reflects profits generated from the firm’s core

 Return on invested capital (ROIC) is superior to ROE and net
operations less income taxes related to the core operations
profit margin in that it focuses on operations and strategy; it is
not affected by financial leverage nor non-operating items in the  EBIT * (1 – tax rate)
financial statements  Operating income * (1 – tax rate)
 Invested capital = The cumulative amount that the business has
invested in its operations – primarily PP&E and working capital.

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Is Growth Always Good? Operating Profit and Free Cash Flow

It depends on the return on capital. Volume Inc.
Volume Inc. plans to reinvest
 Value Inc.: 
Investment rate (IR) 50%
$50 million at a
 ROIC = 10 percent rate of return. Return on new investment 10%

Growth in profits 5%

This investment leads to an

 Volume Inc. 
extra $5 million in profits. Year 1 Year 2 Year 3
 ROIC =
After‐tax operating profit 100.0 105.0 110.3
 For simplicity, we assume all Net investment (50.0) (52.5) (55.1)
ratios, the investment rate,
 Value Inc. generates higher cash flows because it does not and so on never change.
Free cash flow 50.0 52.5 55.1
have to invest as much as Volume Inc., thanks to its higher
ROIC.

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 Which Company Is Worth More? The Drivers of Profit Growth
 Both Volume Inc. and Company B currently generate $100 million  There is a general relationship between IR (investment rate), ROIC
in profit and are expected to grow profits by 5 percent. (return on invested capital), and g (growth).

Volume Inc. Value Inc.
Volume Inc.
Investment rate (IR) 50% Investment rate (IR) 25%
Investment rate (IR) 50% Growth = Reinvestment * Rate of Return
Return on new investment 10% Return on new investment 20%
Return on new investment 10%
Growth in profits 5% Growth in profits 5%
Growth in profits 5%
g = IR * ROIC
Year 1 Year 2 Year 3 Year 1 Year 2 Year 3
Value Inc.
After‐tax operating profit 100.0 105.0 110.3 After‐tax operating profit 100.0 105.0 110.3
Investment rate (IR) 25% Company A:     5% = 50% * 10%
Net investment (50.0) (52.5) (55.1) Net investment (25.0) (26.3) (27.6)
Return on new investment 20%
Free cash flow 50.0 52.5 55.1 Free cash flow 75.0 78.7 82.7
Growth in profits 5%
Company B:     5% = 25% * 20% 

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Valuation with Explicit Forecast

Is Growth Always Good? Period
It depends on the return on capital.  Most companies we evaluate are not in a state of constant growth;
 Consider these two companies. Both firms earned $100m in year 1
we breakdown our valuation into an explicit forecast horizon
(planning period) until we can assume it reaches a constant state of
and increased their revenues and earnings at 5% per year, so their
growth
projected earnings are identical. ∞
$ million Value Inc. 0 5
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 Year 13 Year 14 Year 15 time
Revenue $     1,000 $     1,050 $     1,103 $     1,158 $     1,216 $  1,276 $  1,340 $  1,407 $  1,477 $  1,551 $  1,629 $  1,710 $  1,796 $  1,886 $  1,980
Earnings            100            105            110            116            122         128         134         141         148         155         163         171         180         189         198

Perpetuity
Investment (25%)               25               26               28               29               30            32            34            35            37            39            41            43            45            47            49
Cash Flow $           75 $           79 $           83 $           87 $           91 $        96 $      101 $      106 $      111 $      116 $      122 $      128 $      135 $      141 $  148.5 Explicit Forecast Period
Value today:               68               65               62               59               57            54            52            49            47            45            43            41            39            37            36
(10% discount rate)
Value Inc. Valuation $     1,500 Terminal value at 5% constant growth rate:      3,118
PV of terminal value:         747
𝐹𝐶𝐹 𝑇𝑉
Volume Inc.
𝑃𝑉
Revenue
Year 1
$     1,000
Year 2
$     1,050
Year 3
$     1,103
Year 4
$     1,158
Year 5
$     1,216
Year 6
$  1,276
Year 7
$  1,340
Year 8
$  1,407
Year 9
$  1,477
Year 10
$  1,551
Year 11
$  1,629
Year 12
$  1,710
Year 13
$  1,796
Year 14
$  1,886
Year 15
$  1,980 1 𝑟 1 𝑟
Earnings            100            105            110            116            122         128         134         141         148         155         163         171         180         189         198
Investment (50%)               50               53               55               58               61            64            67            70            74            78            81            86            90            94            99
Cash Flow $           50 $           53 $           55 $           58 $           61 $        64 $        67 $        70 $        74 $        78 $        81 $        86 $        90 $        94 $        99
where
Value today:               45               43               41               40               38            36            34            33            31            30            29            27            26            25            24
𝐹𝐶𝐹 1 𝑔 𝐹𝐶𝐹
𝑇𝑉
(10% discount rate)
Value Inc. Valuation $     1,000 Terminal value at 5% constant growth rate:      2,079
PV of terminal value:         498
𝑟 𝑔 𝑟 𝑔
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 Growth and ROIC: Drivers of
Which Company is Worth More? Value
It depends on the return on capital.
 Assume that a firm earns $100 in its first year, there is a 15-
 Value Inc.: year planning period, a 4.5% terminal growth rate, and a 9%
 P/E = cost of capital
Value ($)
Volume Inc. 3% $800 $1,100 $1,400 $1,600

Growth

6% $600 $1,100 $1,600 $2,100
 P/E = 9% $400 $1,100 $1,900 $2,700
7% 9% 13% 25%
ROIC
 Despite identical earnings and growth rates, the companies
have different earnings multiples because their cash flows are  A typical company has a 9-10% cost of capital, a 13% return
so different. on capital, and revenue growth of 4-5% per year

G = investment rate * ROIC

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Value Creation by Type of Growth

Guiding Principal of Value Creation High ROIC companies should focus on growth. Low ROIC
companies should focus on improving returns before growing.
Value created by different types of growth for a typical consumer products
Firms that grow and earn a return of capital that exceeds their company; results expressed in terms of value created for $1 in incremental
cost of capital create value revenue:
 As long as the spread between ROIC and WACC is positive,
new growth creates value. The faster the firm grows, the more
value it creates.
 If the spread is equal to zero, the firm creates no value through
growth. The firm is growing by taking on projects that have an
NPV of zero.
 When the spread is negative, the firm destroys value by taking
on new projects. If a company cannot earn the necessary return
on a new project or acquisition, its market value will drop.

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 How does a firm create value? Financial value drivers
 Equity valuation
 The intrinsic value of shareholders’ equity is a function of the future
 Financial value drivers free cash flow to equity holders and the cost of equity capital
 Strategic value drivers  Equity cash flows are driven by
 The return on equity capital (ROE)
 The rate of growth in equity capital (g)
 Equity value is created when a firm’s ROE > its cost of equity
 Enterprise valuation
 The intrinsic value of the enterprise is a function of the future free cash
flow to the firm holders and the overall cost of capital (WACC)
 Equity cash flows are driven by
 The return on invested capital (ROIC)
 The rate of growth in total capital (g)
 Enterprise value is created when a firm’s ROIC exceeds its
overall cost of capital (WACC).
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Strategic value drivers: How does a

Growth and ROIC: Drivers of Value firm achieve a high ROIC?
Companies create value for their owners by In perfectly competitive markets, all businesses tend to earn their cost
investing cash today to generate more cash of capital; when forecasting a long-run rate of return, increase/decrease
tomorrow. a firm’s cost of capital depending upon industry structure and the firm’s
Where do earnings fit in? •The amount of value they create is the difference competitive position within the industry
• While earnings and cash between cash inflows and the cost of the
flow are often correlated, investments made, adjusted to reflect the fact that  Industry structure
earnings do not tell the
whole story about value tomorrow’s cash flows are worth less than today’s  Barriers to entry
creation. because of the time value of money and the  Rivalry among existing competitors
• A combination of three riskiness of future cash flows.
primary financial metrics  Bargaining power of suppliers
typically measure how well The core principle of value creation:
a company is delivering
 Bargaining power of buyers
Return on
value to shareholders: Invested  Threat of substitute products
earnings per share, return Capital
on invested capital (ROIC)
or Return on Equity (ROE)
(ROIC)
Cash Flow
 Sustainable competitive advantage
and after-tax cash flow. Revenue
Growth Value  Differentiation (price premium)
Cost of
Capital  Low cost (cost efficiency)
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 Strategic value drivers: How does a
firm achieve a high ROIC?
 Through a source of competitive advantage:
 Differentiation (price premium)
 Innovative product
 Quality
 Brand
 Customer lock-in
 Rational price discipline
 Cost efficiency
 Innovative business model
 Unique resources
 Economies of scale
 Scalable product / process
Examples of Moats
 Low Cost Producer – typically this is achieved through scale
economies
 High Switching Costs – a barrier to entry that involves the one-
time inconvenience or expense a buyer incurs to change over
from one product or service to another
 The Network Effect – occurs when the value of a particular
good or service increases for both new and existing users as
more people use that good or service
 Intangible Assets – intellectual property that firms use to
prevent other companies from duplicating a good or service
“In business, I look for economic
castles protected by
unbreachable ‘moats’.”
- Warren Buffett
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Buffett’s principles for an

outstanding business Foundations of Value
An outstanding business has:  What are the reasons why a large established company
1. a high ROIC and is able to reinvest its earnings at a high might have a low return on capital?
rate  What would cause a small company to have a low return on
2. a “moat”, a barrier against competition, something like a capital?
world-class brand or advantage of scale. Often it is the firms
business in a particular market
3. either an outstanding management or is so powerfully
positioned that it doesn’t need one

Buffett seeks outstanding businesses which fit these three principles. He

hopes to own them for a long time while they compound capital internally.
His ideal holding period is “forever.” This solves the problem of having to
make constant decisions to buy and sell.

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 Valuing Common Stocks – SBUX Valuing Common Stocks – SBUX
Example Example
 Can we apply our equity valuation framework to SBUX? In SBUX Public Market Overview
2005 2006 2007 2008 CAGR
2007, Starbucks’ reinvestment rate was close to 100% and it Revenue $          6,369 $          7,787 $          9,412 $        10,383 18%
was trading at 55x trailing P/E.    By Region:
Asia Pacific 30% 28% 26% 26% 15%
110.00x
EMEA 7% 7% 8% 9% 32%
100.00x Americas 63% 65% 66% 65% 22%
Average historical
90.00x P/E = 55x    By Segment:
Company Operated Retail 85% 85% 85% 84% 0%
80.00x
Licensing 10% 11% 11% 12% 6%
70.00x Foodservice and Other 5% 4% 4% 4% ‐7%
60.00x Gross Margin 59.1% 59.2% 57.5% 55.3% ‐2%
50.00x EPS $0.61 $0.73 $0.87 $0.43 ‐11%
(1)
40.00x Stock Price  $30.45 $35.29 $23.39 $8.93 ‐34%
52wk High             31.96             39.63             36.29             20.45 ‐14%
30.00x
52wk Low             22.78             29.55             20.03               7.17 ‐32%
20.00x P/E 49.61x 51.33x 28.07x 19.07x ‐27%
Apr‐01‐1997

Apr‐01‐1998

Apr‐01‐1999

Apr‐01‐2000

Apr‐01‐2001

Apr‐01‐2002

Apr‐01‐2003

Apr‐01‐2004

Apr‐01‐2005

Apr‐01‐2006

Apr‐01‐2007
Oct‐01‐1997

Oct‐01‐1998

Oct‐01‐1999

Oct‐01‐2000

Oct‐01‐2001

Oct‐01‐2002

Oct‐01‐2003

Oct‐01‐2004

Oct‐01‐2005

Oct‐01‐2006
Total Sales           10,241           12,400           14,505           16,161 16%
In 2005 – 2007, expectations for Starbucks were high, reflected in its P/E ratio.
What happened in 2008?
(1) Pre-adjusted share amounts

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SBUX 6-year Historical Trading Performance SBUX ~ Is Growth Always Good?

Normalized
2005 2006 2007 2008 2009 2010 2011 2012 2013 2013

Net Income $       494 $       564 $       673 $       316 $       391 $       946 $    1,246 $    1,384 $            8 $    1,721
Sales       6,369       7,787       9,412     10,383       9,775     10,707     11,700     13,300     14,892     14,892
Profit Margin 7.8% 7.2% 7.2% 3.0% 4.0% 8.8% 10.6% 10.4% 0.1% 11.6%
Sales       6,369       7,787       9,412     10,383       9,775     10,707     11,700     13,300     14,892     14,892
Assets       3,514       4,429       5,344       5,673       5,577       6,386       7,360       8,219     11,517     11,517
Asset Utilization 1.81x 1.76x 1.76x 1.83x 1.75x 1.68x 1.59x 1.62x 1.29x 1.29x
Assets       3,514       4,429       5,344       5,673       5,577       6,386       7,360       8,219     11,517     11,517
In 2007, same-store sales Equity       2,101       2,239       2,301       2,509       3,057       3,682       4,387       5,115       4,482       4,482
growth slowed to flat in 2Q Equity Multiplier 1.67x 1.98x 2.32x 2.26x 1.82x 1.73x 1.68x 1.61x 2.57x 2.57x
and negative in 3Q in the ROE 23.5% 25.2% 29.2% 12.6% 12.8% 25.7% 28.4% 27.1% 0.2% 38.4%
U.S. This was Starbucks’
first quarterly flat and  SBUX ROE declined from 29.2% to 12.6%. Net margin fell from 7% to 3%
negative traffic since 1998. and EBITDA margin from 15% to 12%.
 The company experienced growth in sales and stores, but due to lower
return on capital, the company destroyed value for shareholders.

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 Life Cycle of a Company and
SBUX 10-year Historical Trading Performance Value Creation
In 2008, SBUX US was at
50% of their 20,000 total
store target.
They faced increased
competition and their
return on incremental
capital was lower.

They experienced increased cannibalization

of existing stores from new ones and faced
difficulty managing costs due to rising
commodity costs and labor expenses.

They began to restructure and close less

profitable stores and emphasize to the investor
community that their int’l market was young
(only 9% of profits / China had potential)
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ROIC by
Industry Summary
 Growth is not always good
 A company earning a return higher than its cost of capital should
increase growth to increase value
 High ROIC companies should focus on growth. Low ROIC
companies should focus on improving returns before growing
 A sustainable competitive advantage is based on the attractiveness
of the industry, the business model, the length of the life cycles of its
businesses/products, the length of time its competitive advantages
can persist, and its potential for renewing businesses and products.

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Source: Koller text
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