Unformatted text preview: Applied Equity Analysis and Por3olio Management Lecture 2 Valua;on 101 • A company is worth the sum of the future cash ﬂows that it is able to generate • Investors will adjust the value or “discount” these cash ﬂows based on risk PV of Cashﬂow from Opera;ons PV of Cashﬂow from Non Opera;ng Ac;vi;es = Enterprise Value Cash Available to Debt Equivalents Cash Available to Equity Equivalents 2 A Model of Two Simple Companies • Company A earns $100 million a year in proﬁt. The $100 million is based on an asset base which does not depreciate. • Part of the proﬁt will be reinvested into the business, the remainder distributed to investors. $50 NOPAT = $100 Reinvested in business $50 Returned to investors Reinvestment Rate = 50% Payout Rate = 50% Net Opera;ng Proﬁt ATer Tax (NOPAT) = EBIT x (1 – Tax Rate) 3 Opera;ng Proﬁt and Free Cash Flow • The company plans to reinvest $50 million at a 10 percent rate of return. • This investment leads to an extra $5 million in proﬁts. • For simplicity, we assume all ra;os, the investment rate, and so on never change. Company A Investment rate (IR) Return on new investment Growth in proﬁts 50% 10% 5% Year 1 ATer
tax opera;ng proﬁt Net investment Free cash ﬂow 100.0 (50.0) 50.0 Year 2 105.0 (52.5) 52.5 Year 3 110.3 (55.1) 55.1 4 Calcula;ng Incremental Cash Flows Cash Flow from Operations Cash Flow to Investment = Free Cash Flow Revenues
EBITDA New Investment in PPE & Goodwill
EBIT NOPAT  Expenses  Depreciation  Taxes + Depreciation + Additions to Net WC + Additions to Other Operating Assets  Additions to Other Non Interest Bearing Operating Liabilities
= Cash Flow to Investment = Cash Flow from Operations
Note that depreciation provides a “tax shield” each year equal to the tax rate times the depreciation.
EBITDA = Earnings before interest, taxes, depreciation and amortization EBIT = Earnings before interest and taxes NOPAT = Net operating profit after taxes 5 Growth, Reinvestment and Free Cash Flow • • • • Both company A and company B have a star;ng income of $100 million Assume both companies have a WACC of 10% Both incomes are expected to grow at 5% Which company would you prefer to own? Company B IR = Investment rate = 25% R = Return on net investment = 20% g = Growth in profits = 5% Company A IR = Investment rate = 50% R = Return on net investment = 10% g = Growth in profits = 5% Year 1 Profit  Net investment = Free cashflow 100 50 50 Year 2 105 53 53 Year 3 110 55 55 Profit  Net investment = Free cashflow Year 1 100 25 75 Year 2 105 26 79 Year 3 110 28 83 6 SBUX Free Cash Flow 7 Growth Company A IR = Investment rate = 50% R = Return on net investment = 10% g = Growth in profits = 5% Growth = Reinvestment * Return g = IR * R Company B IR = Investment rate = 25% R = Return on net investment = 20% g = Growth in profits = 5% Company A: Company B: 5% = 50% * 10% 5% = 25% * 20% 8 What Drives Value? But what determines cash ﬂow? As cash ﬂow rises, what happens to value? As weighted average cost of capital (WACC) rises, what happens to value? As growth rises, what happens to value? 9 Key Value Drivers • In order to develop the key value driver formula, we will rely on two simple subs;tu;ons. • Subs;tu;on #1: g = IR * R IR = g R • Subs;tu;on #2 Cashﬂow = Proﬁt (1
Reinvestment Rate) ȹ g ȹ Profit ȹ1 − ȹ Cashflow1 Profit(1 − IR) ȹ R Ⱥ Value = = = WACC − g WACC − g WACC − g 10 Key Value Drivers • Our formula can be transcribed into standard terms: ȹ g ȹ Profit ȹ1 − ȹ ȹ R Ⱥ Value = WACC − g ȹ g ȹ NOPATȹ1 − ȹ ȹ ROIC Ⱥ Value = WACC − g € 11 The Growth/Value Matrix • If the spread between ROIC and WACC is posi;ve, new growth creates value. • The market value of a company with a star;ng proﬁt of $100 million and a 10 percent cost of capital is as follows: ROIC 7.5% 2% Growth 4% 6% $917 778 500 10.0% $1,000 1,000 1,000 12.5% $1,050 1,133 1,300 15.0% $1,083 1,222 1,500 12 How Growth Drives Value • In 1995, two Fortune 500 companies had $20 billion in revenue. Since then one company has grown drama;cally. Which company is the high
growth company, A or B? Aggregate Revenues 1995−2009
80 Company A
Market cap ($ billion) Enterprise value ($ billion) Forward P/E (FYE '10) 124.3 133.6 16.4 1.9 20.0% 12.0%
60 PEG ratio (5year expected) ROIC (via Thomson First Call) $ billion 40 Company B
Market cap ($ billion) 26.0 28.3 21.0 1.0 12.0% 4.6%
20 Enterprise value ($ billion) Forward P/E (FYE '10) PEG ratio (5year expected) ROIC (via Thomson First Call) 0 1995 1998 2001 2004 2007 Source: Thomson First Call, February 2010. 13 The Value of Alterna;ve Strategies ROIC 7.5% 2% Growth 4% 6% $917 778 500 10.0% $1,000 1,000 1,000 12.5% $1,050 1,133 1,300 15.0% $1,083 1,222 1,500 • Assume your company earns a 15 percent return on invested capital, while growing at 2 percent. The new CEO has argued that the company should grow faster, even if it means sacriﬁcing some ﬁnancial performance. What do you think? Assume your company earns a 10 percent return on invested capital, while growing at 6 percent. The new CEO has argued that the company should focus on higher
proﬁt customers, even if it means reducing growth. What do you think? 14 • ...
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