McKinsey on Valuation - Part One Flashcards
How do invested capital and cost of capital relate when creating real value?
To create real value, the rate of return of invested capital should exceed the cost of capital
What is a simple calculation of whether a business is creating value?
Companies that grow and earn a return on capital that exceeds their cost of capital create value.
What is the danger that comes from managers focusing very closely on EPS?”
It is a short-term metric, so managers may forego projects that will create value over the long-term if there would be a short-term drop in EPS
Empirically, is there a link between EPS accretion and long-term value creation from acquisitions?
No, no empirical evidence that likes increased EPS with the value created by a transaction. Deals that strengthen EPS and deals that dilute EPS are equally likely to create or destroy value.
What is the link between employment growth in public companies and TSR?
Those with highest employee growth had the highest TSR, implying that they create the most value
How does competition affect ROIC?
Erodes it. Therefore, companies must continually seek and exploit new sources of competitive advantage if they are to create long-term value.
Why is maximising current share price not equivalent to maximising long-term value?
May forego projects that would short-term dampen earnings (and hence likely decrease share price) because of the initial investment, but long-term, would create new and profitable business opportunities
What is the link between NOPAT, ROIC, and free cash flow?
Higher NOPAT doesn’t necessarily leader to higher cash flow if all the growth is coming from investing (i.e. capex). This is because, although NOPAT is higher, your fixed assets will be growing in size too, which can cause the denominator to increase and cash flow to decrease (Capex is subtracted when calculating cash flow)
However, if you have higher NOPAT with a higher ROIC, you will end up with more cash flow, as this implies that you are growing your operating profits through other methods than capex. Usually, these other methods come from competitive advantages, rather than just growing the business through investment.
What is an alternative way of thinking about ROIC rather than just D + E
The compromise ROIC is thus: after-tax operating profit divided by assets minus noninterest-bearing current liabilities minus excess cash
When considering ROIC, when should you decide to close certain aspects of the business?
When they are earning lower ROIC than the cost of capital. Even if you have two stores, and one has much higher ROIC, you should still keep the second if that stores ROIC is greater than the cost of capital.
If two companies grow at the same rate but one needs a higher reinvestment rate to maintain this growth, which is valued higher?
One with lower reinvestment rate, as cash flow will be higer
What is the formula for growth in regards to ROIC and investment rate?
Growth = ROIC x Investment rate
Investment rate is the yearly investment needed to produce yearly cash flow.
Therefore, higher ROIC means that you need lower investment in order to achieve the same amount of growth
What is the formula for cash flow in regards to earnings and investment rate?
Cash flow = Earnings x (1-Investment Rate)
How can formula for cash flow (earnings and investment rate) relate to formula for investment rate (growth, roic)?
Cash flow = Earnings x (1-Growth/ROIC)
How does ROIC help explain why mature tech and pharma companies with high ROIC return lots of cash flow to investors?
Generate more cash flow than they can reinvest at attractive returns on capital
