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.
