Wacc
where, Economic profitT 1 The normalized economic profit in the first year after the explicit forecast period. NOPLATt 1 The normalized NOPLAT in the first year after the explicit forecast period. g The expected growth rate in NOPLAT in perpetuity. ROICj The expected rate of return on net new investment. WACC The weighted average cost of capital. This formula says that the value of economic profit after the explicit forecast equals the present value of economic profit in the first year after...
Formula for Estimating the WACC
The general formula for estimating the after-tax WACC is simply the weighted average of the marginal after-tax cost of each source of capital where kb The pretax market expected yield to maturity on noncallable, nonconvertible debt Tc The marginal tax rate for the entity being valued2 B The market value of interest-bearing debt V The market value of the enterprise being valued V B P S kp The after-tax cost of capital for noncallable, nonconvertible preferred stock which equals the pretax cost...
Ex Ante Market Reactions
Exhibit 7.1 summarizes the results of dozens of academic studies of transactions involving public companies. Shareholders of acquired companies are the big winners, receiving on average a 20 percent premium in a Exhibit 7.1 Empirical Studies of M amp A Activity Exhibit 7.1 Empirical Studies of M amp A Activity friendly merger and a 35 percent premium in a hostile takeover. Shareholders of acquiring companies, on average, earned small returns that are not even statistically different from zero....
Goodwill
We explicitly excluded goodwill, both the asset and the amortization, from the calculation of ROIC. In most cases, ROIC should be calculated both with and without goodwill. ROIC excluding goodwill measures the operating performance of the company and is useful for comparing operating performance across companies and for analyzing trends. It is not distorted by the price premiums paid for acquisitions made in building the company. ROIC including goodwill measures how well the company has used...
Noplat
Invested capital Operating working capital Net property, plant, and equipment Other assets Earlier in this chapter see Exhibit 8.4 , we defined free cash flow as equal to gross cash flow NOPLAT plus depreciation minus gross investment increases in working capital plus capital expenditures . To simplify the following examples, we will show free cash flow as NOPLAT less net investment, having subtracted depreciation from both gross cash flow and gross investment. In year 1, Company A's NOPLAT...
Info Rth
Projected free cash flow NLG millions There is not much interesting to say about this series of numbers. But now look at Heineken's performance from the perspective of growth and ROIC. Actual 1994-98 Projected 1999-2003 ROIC after goodwill 12.3 12.3 With this information, we can understand intuitively how Heineken is performing. We can assess its growth relative to the industry. We can evaluate whether its ROIC is improving or deteriorating and how it compares with other branded consumer...
Summary
In this chapter we discussed a comprehensive framework to cut through the confusion of proliferating metrics. Shareholder value in the stock market is the ultimate output measure of a company's performance. Shareholder value tracks a company's intrinsic value based on discounted cash flows. While valuable for strategic analysis, DCF cannot be used to assess historical performance or set short-term targets. Financial indicators like revenue growth and ROIC drive DCF values and can be used to set...
Managing the Corporate Portfolio
To maximize value, a company must determine to what extent its current portfolio of businesses will help it meet its aspirations. Building a portfolio is not just a financial exercise, since shareholders can buy and sell shares of various companies to get the reward risk tradeoff they prefer. Instead, it is a combination of exploiting the strategic advantages of the corporation, relentlessly looking for performance improvement opportunities, and managing a growth pipeline. Three perspectives on...
A ValueLinked Quantitative Target
Companies need to mark the milestones toward their aspiration with value-linked targets. Some companies target their share price, promising to double it in three, four, or five years. Others target key value drivers, whether these are expressed in financial terms e.g., EBIT or operational terms e.g., number of customers . How should companies set their overall targets There is no one deductive method that will tell management ''how much is enough. However, there are three kinds of analysis that...
An Inspirational Statement of Intent
For most companies, stating that their goal is to maximize shareholder value is not enough to excite employees, focus organizational energy, or direct their long-term ambitions. Thus, companies often develop broader statements of purpose. A good example is Disney, whose mission is ''To offer quality entertainment that people will seek out and whose vision is To create shareholder value by continuing to be the world's premier entertainment company from a creative, strategic, and financial...
Setting Aspirations and Targets
The principles of making value happen can be powerful tools to help a company achieve its goals provided it knows what these goals are and how they link to value creation. All too often, a company's externally communicated goals represent just an incremental increase over historical performance, and may link more to accounting measures such as earnings per share than to more economically based measures. Equally, its internally communicated goals, as embodied in a mission or vision statement,...
Making Value Happen
Most publicly traded companies today have a stated aim of creating value for their shareholders. The question for many managers is not ''Why should we create value but How can we create value This question translates into issues in a number of areas, such as How can we set targets that reinforce our overall goal of creating shareholder value How can we align our management processes with the goal of value creation How should we structure our incentive programs How can we promote a value...
Implications of Market Inefficiency for Corporate Managers
Sometimes managers point to evidence of inefficiency in the stock market to justify their belief that the market behaves irrationally. These managers would argue that even academics are finding inefficiencies in the market, so any argument supporting the discounted cash flow approach would not 11 G. Mercer, ''A Review of Major Corporate Writeoffs, 1984-86 McKinsey amp Co., 1987 . 12 T. Copeland and W.H. Lee, Exchange Offers and Stock Swaps New Evidence, Financial Management, vol. 20, no. 3...
Cash Is King On October 1 1974
Nmei 12' r V oirit rate assumed, iourte Compustat. Exhibit 5.9 Evidence That the Market Reacts Favorably to Increases in Investment Exhibit 5.9 Evidence That the Market Reacts Favorably to Increases in Investment dividends over the next several years. For a random sample of 20 Fortune 500 companies, as shown in Exhibit 5.8, an average of only 9.2 percent of the total share value could be accounted for by dividends expected in the next five years. The largest percentage of value that the next...
Cash Is King On October 1 1974
-12 -6 0 6 12 Months from the date of accounting change -12 -6 0 6 12 Months from the date of accounting change Souric i. Sunder, The Relationship Between Accounting Changes and Stock Prices Problems ol Measurement and Some Empirical viil ence ,nl Empirical Research in Accounting Selected Studies 1973 18. to increased cash flow, which is what the DCF model predicts. After adjusting for movements in the broad market and other contemporaneous effects, companies switching to LIFO experienced...
Cash Is King On October 1 1974
If the market just looked at reported earnings, which would it use It wouldn't use either one, it would have to look deeper than reported earnings. A classic area of research on this topic is inventory accounting. U.S. tax authorities require that the method used for financial reporting also be used for calculating taxable income. As a result, the choice of accounting method affects both earnings and cash flow, but in opposite directions. In periods of rising prices, the last-in, first-out LIFO...
Market Sees through Cosmetic Earnings Effects
Does the market respond naively to accounting numbers or does it look deeper Many managers seem obsessed with reported earnings. Yet, the evidence is clear The market looks much deeper than reported earnings. The simplest piece of evidence comes from companies that use different accounting methods depending on the market in which they are reporting financial results. Hoechst was one of the largest German industrial companies, with over DM 50 billion in revenues in 1997. Hoechst listed its...
Cash Is King On October 1 1974
into different spread cohorts and conducted separate regressions of market-to-book against growth. As the theory would predict, growth is much more important for high spread companies as shown on Exhibit 5.4. The slope of the regression line for high spread companies is significantly positive for low spread companies it is relatively flat and not statistically different than zero. In another test, we applied the DCF approach to the valuation of 31 companies. We developed cash-flow forecasts...
TRS Linked to Changes in Expectations
In Chapter 4, we made the case that total returns to shareholders are linked more to performance against expectations than absolute levels of performance. For example, on October 15, 1997, Intel reported that its earnings were up 19 percent compared with the previous year. Intel's share price declined 6.3 percent on the announcement because analysts had forecast a 23 percent increase in earnings. Over horizons of at least 15 years, TRS will be linked to earnings because earnings growth will...
Cash Is King
On October 1, 1974, the Wall Street Journal published an editorial lamenting the widespread focus on earnings per share as an indicator of value A lot of executives apparently believe that if they can figure out a way to boost reported earnings, their stock prices will go up even if the higher earnings do not represent any underlying economic change. In other words, the executives think they are smart and the market is dumb. . . . The market is smart. Apparently, the dumb one is the corporate...