Valuation Part 1

Question 1

What is the Definition of value creation for the Firm?

Answer 1

The Return on Capital Employed (ROCE) must exceed the Cost of Capital (WACC)

Question 2

What is the Definition of value creation for the Shareholders?

Answer 2

The return on equity is higher than what was expected (Cost of Equity)

Question 3

What is the Definition of value creation from investments?

Answer 3

The internal Rate of Return is higher than the cost of financing (WACC)

Question 4

What is the Definition of value creation from M&A?

Answer 4

The cumulated synergies are higher than the premium paid

Question 5

Formula for Earnings per Share (EPS)

Answer 5

EPS = NET INCOME / shares outstanding

Question 6

Formula for Investment Rate (IR)

Answer 6

NET INVESTMENT / NOPAT

portion of NOPAT invested back into the business

Question 7

Formula for Growth

Answer 7

GROWTH = ROIC * INVESTMENT RATE

Question 8

Formula for Cash Flow?

Answer 8

CASH FLOW = EARNINGS * (1- INVESTMENT RATE)

OR

CASH FLOW = EARNINGS * (1-(GROWTH/ROIC))

Question 9

Translating Growth and ROIC into Cash Flow Available for Distribution

Answer 9

Question 10

Translating Growth and ROIC into Value

Answer 10

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.

Question 11

What is the Formula for Economic Profit?

Answer 11

ECONOMIC PROFIT = INVESTED CAPITAL * (ROIC - COST OF CAPITAL)

Question 12

Conservation of Value rule

Answer 12

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.

Question 13

When can we say that share repurchases create Value?

Answer 13

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.

Question 14

When do acquisitions create value?

Answer 14

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.

Question 15

Explain multiple expansion? Does it hold?

Answer 15

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.

Question 16

Net operating profit after taxes (NOPAT)

Answer 16

represents the profits generated from the company’s core operations after subtracting the income taxes related to those core operations.

Question 17

Invested capital

Answer 17

Represents the cumulative amount the business has invested in its core operations—primarily property, plant, and equipment and working capital.

Question 18

Net investment

Answer 18

increase in invested capital from one year to the next: NET INVESTMENT = INVESTED CAPITAL_(t+1) - INVESTED CAPITAL_(t)

Question 19

Free cash flow (FCF) or better free operating cash flow

Answer 19

cash flow generated by the core operations of the business after deducting investments in new capital: FCF = NOPAT - NET INVESTMENT

Question 20

Return on invested capital (ROIC)

Answer 20

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.

Question 20

Weighted average cost of capital (WACC) in words

Answer 20

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.

Question 21

Growth (g)

Answer 21

rate at which the company’s NOPAT and cash flow grow each year

Question 22

Under what circumstances does growth destroy value?

Answer 22

If ROIC is below the cost of capital.

Question 23

effect of diversification on the cost of capital

Answer 23

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.

Question 24

What is the advantage of having multiple cash flow scenarios?

Answer 24

• 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.

Question 25

Formula Total shareholder return (TSR) - has some fallacies

Answer 25

TSR = % CHANGE IN MARKET VALUE + DIVIDEND YIELD

OR

TSR = % CHANGE IN NET INCOME + % CHANGE IN P/E + DIVIDEND YIELD

Question 26

P/E Ratio

Answer 26

P/E = SHARE PRICE / EPS

Question 27

EPS

Answer 27

EPS = NET INCOME / SHARES OUTSTANDING

Question 28

Why is the traditional approach of non-decomposed TSR technically correct but not great in use?

Answer 28

• 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

Question 29

Decomposed TSR image

Answer 29

Question 30

% Change in Net Income Formula

Answer 30

% CHANGE NET INCOME = % CHANGE REVENUES + IMPACT OF PROFIT MARGIN ON NET INCOME

Question 31

DIVIDEN YIELD

Answer 31

DIVIDEND YIELD = DIVIDENDS / MARKET VALUE

Question 32

DECOMPOSED TSR IF ALL EXCESS CASH IS PAID OUT AS DIVIDENDS

Answer 32

TSR = (NET INCOME / MARKET VALUE) - (INVESTMENTS / MARKET VALUE) + CHANGE IN PROFIT MARGIN + % CHANGE IN REVENUE + % CHANGE IN P/E

Question 33

5 Factors that drive TSR

Answer 33

1. REVENUE GROWTH
2. INVESTMENT REQUIRED TO ACHIEVE THAT GROWTH
3. % IMPACT OF CHANGE IN MARGIN ON NET INCOME
4. STARTING RATIO OF NET INCOME TO MARKET VALUE (INVERSE OF P/E)
5. CHANGE IN P/E RATIO

Question 34

Rearrange Investment / Market Value for growth and ROIC

Answer 34

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)

Question 35

show that the ratio of net income to market value is just the inverse of the P/E

Answer 35

1 / P/E = EPS / Share Price = (Net Income / shares outstanding) * (1 / share price) = Net income / Market Value

Question 36

earnings yield

Answer 36

Zero growth and no change in expectations

Earnings Yield = 1/ (P/E) = Net Income / Market Value

Question 37

Earnings Yield

Answer 37

Earnings Yield = 1/(P/E)

Question 37

ESG link to cash flow

Answer 37

1. facilitating revenue growth
2. cut costs (only you or whole indudstry?)
3. minimize regulatory and legal interventions, maybe even government support
4. increase talent attraction and employee productivity
5. optimize investments and capital expenditure

Question 37

Value ESG investments

Answer 37

try to quantify with scenarios. crux is that here the base case often leads to eroding revenue.

Question 37

Consider the top 3 drivers of EPS growth

Answer 37

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.