Valuation Part 1 Flashcards
What is the Definition of value creation for the Firm?
The Return on Capital Employed (ROCE) must exceed the Cost of Capital (WACC)
What is the Definition of value creation for the Shareholders?
The return on equity is higher than what was expected (Cost of Equity)
What is the Definition of value creation from investments?
The internal Rate of Return is higher than the cost of financing (WACC)
What is the Definition of value creation from M&A?
The cumulated synergies are higher than the premium paid
Formula for Earnings per Share (EPS)
EPS = NET INCOME / shares outstanding
Formula for Investment Rate (IR)
NET INVESTMENT / NOPAT
portion of NOPAT invested back into the business
Formula for Growth
GROWTH = ROIC * INVESTMENT RATE
Formula for Cash Flow?
CASH FLOW = EARNINGS * (1- INVESTMENT RATE)
OR
CASH FLOW = EARNINGS * (1-(GROWTH/ROIC))
Translating Growth and ROIC into Cash Flow Available for Distribution
Translating Growth and ROIC into Value
One exception is young firms. There even with initial low ROIC it might make sense to invest heavily in growth under the assumption that ROIC will still increase.
What is the Formula for Economic Profit?
ECONOMIC PROFIT = INVESTED CAPITAL * (ROIC - COST OF CAPITAL)
Conservation of Value rule
Value is conserved, or unchanged, when a company changes the ownership of claims to its cash flows but doesn’t change the total available cash flows—for example, when it substitutes debt for equity or issues debt to repurchase shares.
When can we say that share repurchases create Value?
When the likelyhood of investing cash at lower returns than the cost of capital is high, share repurchases make sense as a tactic for avoiding value destruction. But they do not, themselves, create value.
When do acquisitions create value?
Acquisitions create value only when the combined cash flows of the two companies increase due to cost reductions, accelerated revenue growth, or better use of fixed and working capital.
Explain multiple expansion? Does it hold?
If multiple expansion were true, all acquisitions would create value because the P/E on the lower-P/E company’s earnings would rise to that of the company with the higher P/E, regardless of which was the buyer or seller. No Data exists to support this.
Net operating profit after taxes (NOPAT)
represents the profits generated from the company’s core operations after subtracting the income taxes related to those core operations.
Invested capital
Represents the cumulative amount the business has invested in its core operations—primarily property, plant, and equipment and working capital.
Net investment
increase in invested capital from one year to the next: NET INVESTMENT = INVESTED CAPITAL_(t+1) - INVESTED CAPITAL_(t)
Free cash flow (FCF) or better free operating cash flow
cash flow generated by the core operations of the business after deducting investments in new capital: FCF = NOPAT - NET INVESTMENT
Return on invested capital (ROIC)
the return the company earns on each dollar invested in the business: ROIC = NOPAT / INVESTED CAPITAL
*ROIC can be defined in two ways: as the return on all capital or as the return on new, or incremental, capital. For now, we assume that both returns are the same.
Weighted average cost of capital (WACC) in words
is the rate of return that investors expect to earn from investing in the company and therefore the appropriate discount rate for the free cash flow.
Growth (g)
rate at which the company’s NOPAT and cash flow grow each year
Under what circumstances does growth destroy value?
If ROIC is below the cost of capital.
effect of diversification on the cost of capital
If diversification reduces risk to investors and it is not costly to diversify, then investors will not demand a higher return for any risks that can be eliminated through diversification. They require compensation only for risks they cannot diversify away.
What is the advantage of having multiple cash flow scenarios?
- provides decision makers with more information. Making implicit risk assumptions explicit encourages dialogue about the risk of the project.
- Encourages mangers to develop strategies to mitigate specific risks, because it explicitly highlights the impact of failure or less than complete success.
- Acknowledges full range of possible outcomes.
Formula Total shareholder return (TSR) - has some fallacies
TSR = % CHANGE IN MARKET VALUE + DIVIDEND YIELD
OR
TSR = % CHANGE IN NET INCOME + % CHANGE IN P/E + DIVIDEND YIELD
P/E Ratio
P/E = SHARE PRICE / EPS
EPS
EPS = NET INCOME / SHARES OUTSTANDING
Why is the traditional approach of non-decomposed TSR technically correct but not great in use?
- misses that not all forms of income growth are the same
- misses that dividends are simply a residual and cannot be changed without affecting future cash flows or dividends
- misses that financial leverage or the capital structure influences the risk profile and therefore the TSR
Decomposed TSR image
% Change in Net Income Formula
% CHANGE NET INCOME = % CHANGE REVENUES + IMPACT OF PROFIT MARGIN ON NET INCOME
DIVIDEN YIELD
DIVIDEND YIELD = DIVIDENDS / MARKET VALUE
DECOMPOSED TSR IF ALL EXCESS CASH IS PAID OUT AS DIVIDENDS
TSR = (NET INCOME / MARKET VALUE) - (INVESTMENTS / MARKET VALUE) + CHANGE IN PROFIT MARGIN + % CHANGE IN REVENUE + % CHANGE IN P/E
5 Factors that drive TSR
- REVENUE GROWTH
- INVESTMENT REQUIRED TO ACHIEVE THAT GROWTH
- % IMPACT OF CHANGE IN MARGIN ON NET INCOME
- STARTING RATIO OF NET INCOME TO MARKET VALUE (INVERSE OF P/E)
- CHANGE IN P/E RATIO
Rearrange Investment / Market Value for growth and ROIC
First :
Investment = Net Income * (growth / ROIC)
Then:
Investment / Market Value = Net Income / Market Value * Growth / ROIC
So:
Investment / Market Value =
(1/ P/E) * (growth / ROIC)
show that the ratio of net income to market value is just the inverse of the P/E
1 / P/E = EPS / Share Price = (Net Income / shares outstanding) * (1 / share price) = Net income / Market Value
earnings yield
Zero growth and no change in expectations
Earnings Yield = 1/ (P/E) = Net Income / Market Value
Earnings Yield
Earnings Yield = 1/(P/E)
ESG link to cash flow
- facilitating revenue growth
- cut costs (only you or whole indudstry?)
- minimize regulatory and legal interventions, maybe even government support
- increase talent attraction and employee productivity
- optimize investments and capital expenditure
Value ESG investments
try to quantify with scenarios. crux is that here the base case often leads to eroding revenue.
Consider the top 3 drivers of EPS growth
1) We have seen that organic revenue growth is a great value driver if it generates a return on invested capital exceeding the cost of capital.
2) margin improvements that come solely via cost cutting are not sustainable and might even hurt growth. Old story of cutting research and development investment. If the margin improvement comes through operational productivity increase, it is a good value driver.
3) share repurchases increase debt or decrease cash, or both. In either case it leads to reduced P/E which has an effect on the initial larger EPS so that the value per share does NOT change.
