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 Reinvestment Rate = 50% Returned
to investors 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) 50% Return on new investment 10% Growth in proﬁts 5% Year 1 Year 2 Year 3 ATer tax opera;ng proﬁt 100.0 105.0 110.3 Net investment (50.0) (52.5) (55.1) Free cash ﬂow 50.0 52.5 55.1 4 Calcula;ng Incremental Cash Flows Cash Flow from Operations  Cash Flow to Investment = Free Cash Flow New Investment in PPE &
Goodwill Revenues
EBITDA  Expenses
 Depreciation EBIT + Additions to Net WC
NOPAT  Taxes
+ Depreciation
= Cash Flow from Operations
Note that depreciation provides a “tax shield” each
year equal to the tax rate times the depreciation. + Additions to Other Operating
Assets
 Additions to Other Non Interest
Bearing Operating Liabilities
= Cash Flow to Investment 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 $100 million Assume both companies have a WACC of 10% Both incomes are expected to grow at 5% Which company would you prefer to own? Company A Company B IR = Investment rate = 50% IR = Investment rate = 25% R = Return on net investment = 10% R = Return on net investment = 20% g = Growth in profits = 5% g = Growth in profits = 5% Year 1 Year 2 100 105 110  Net investment 50 53 55 = Free cashflow 50 53 55 Year 1 Year 2 Year 3 100 105 110  Net investment 25 26 28 = Free cashflow 75 79 83 Year 3 Profit Profit 6 UNH Free Cash Flow 7 Compara;ve Free Cash Flow Industry has paid out 100% of its FCF over the last 5 years Growth Company A
IR = Investment rate = 50% Growth = Reinvestment * Return R = Return on net investment = 10%
g = Growth in profits = 5% g = IR * R Company B
IR = Investment rate = 25% Company A: 5% = 50% * 10% R = Return on net investment = 20% Company B: 5% = 25% * 20% g = Growth in profits = 5% 9 What Drives Value? Cash Flow1
Value =
WACC − g But what determines cash ﬂow? As cash ﬂow rises, what happens to value? As weighted average cost of capital (WACC) rises, what happens to value? As growth rises, what happens to value? 10 Key Value Drivers • In order to develop the key value driver formula, we will rely on two simple subs;tu;ons. • Subs;tu;on #1: g = IR * R IR = g
R • Subs;tu;on #2 Cashﬂow = Proﬁt (1 Reinvestment Rate) ' g$
Profit %1 − "
Cashflow1
Profit(1 − IR)
& R#
Value =
=
=
WACC − g
WACC − g
WACC − g 11 Key Value Drivers • Our formula can be transcribed into standard terms: ' g$
Profit %1 − "
& R#
Value =
WACC − g #
g&
NOPAT%1 −
(
$ ROIC '
Value =
WACC − g € 12 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 10.0% 12.5% 15.0% $917 $1,000 $1,050 $1,083 4% 778 1,000 1,133 1,222 6% 500 1,000 1,300 1,500 13 How Growth Drives Value In 1995, two Fortune 500 companies had $20 billion in revenue. Since then one company has grown drama;cally. Which company is the high growth company, A or B? Aggregate Revenues 1995−2009 Company A
Market cap ($ billion) 124.3 Enterprise value ($ billion) 80 133.6 Forward P/E (FYE '10) 12.0% PEG ratio (5year expected)
ROIC (via Thomson First Call) 60 $ billion • 16.4
1.9
20.0% Company B 40 Market cap ($ billion) 4.6%
20 26.0 Enterprise value ($ billion) 28.3 Forward P/E (FYE '10) 21.0 PEG ratio (5year expected)
ROIC (via Thomson First Call) 0 1.0
12.0% Source: Thomson First Call, February 2010.
1995 1998 2001 2004 2007 14 The Value of Alterna;ve Strategies ROIC
7.5% 12.5% 2% $917 $1,000 $1,050 $1,083 4% 778 1,000 1,133 1,222 6% Growth 10.0% 15.0% 500 1,000 1,300 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? 15 ...
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 Spring '11
 Perfetti
 Management

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