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Introduction to Valuation

Introduction to Valuation Centre for Financial and Management Studies

© SOAS University of London First published: 2013; Revised: 2016, 2019

All rights reserved. No part of this module material may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, including photocopying and recording, or in information storage or retrieval systems, without written permission from the Centre for Financial and Management Studies, SOAS University of London.


Module Introduction and Overview

Contents

1 Introduction to the Module 2

2 The Module Authors 3

3 Study Materials 3

4 Module Overview 4

5 Learning Outcomes 6

6 Assessment 7

Specimen Examination 15


2 University of London

1 Introduction to the Module This module introduces concepts and tools for valuing companies in a

consistent manner. You should find it useful as a starting point and guide

for analysing the performance of companies and industries of your interest,

and for interpreting and assessing valuations.

The module should be useful for practitioners working in various market

environments – from developed countries to emerging markets, from

services to manufacturing industries, and from the viewpoints of managers

to the desks of stock analysts.

The field of valuation has evolved over time, along with the changing nature

of markets, firms and corporations. While much of the development in this

area is encouraged by the need to measure company performance and

profitability for the purpose of equity price valuation, valuation is also

useful for understanding business conditions and the drivers behind them,

for evaluating your own and competing companies, for peers in the indus-

try, and even for suppliers and customers along the production chain.

While the module is meant to apply to various business settings, certain

assumptions underline the material:

• that the markets perform well, close to perfect competition and complete information

• that the business decisions that result in corporate performance are made in the best interests of stakeholders

• that the processes of valuation are done with the correct information and for all possible scenarios.

The main part of this module takes a deterministic approach to valuing

companies, in which the valuation assumes away most of the errors, ran-

domness, and mismeasurement in the company’s financial information.

While the module introduces several sensitivity and scenario analyses, you

are reminded, where applicable, of the shortcomings of the basic models and

the key limitations of the approaches taken. This module focuses on the

baseline analysis so that you have an understanding of the tools and con-

cepts necessary for pursuing further more advanced materials.

When you work through the module materials, there are various exercises

based upon the textbook, the readings and the unit content. These are

designed to consolidate your knowledge and skills. We recommend that you

do the exercises, most of which take half an hour or less, before you look at

the answers that are provided in the unit text.

At certain points we will ask you to reflect on various aspects of the valua-

tion process in relation to companies with which you are familiar. It will be

valuable for you and your fellow students to share these reflections on the

VLE. Short notes setting out the issue and the approach will enrich your

experience of the module.

Please feel free to raise queries with your tutor and with your fellow stu-

dents, if there are things that are not clear to you. Do this as soon as you find

a problem, because waiting will hold you up as you work through the module.

We hope that you will find the module instructive, useful and challenging.


Centre for Financial and Management Studies 3

2 The Module Authors Yothin Jinjarak was a Reader in Banking and Finance in the Department of

Financial and Management Studies at SOAS. He has published in Journal of

Banking and Finance, the Journal of International Money and Finance, the Journal

of Financial Stability, and other finance and economics journals. In addition to

his position at SOAS, he has held consultancies with the World Bank, the

United Nations, ASEAN Secretariat and the Asian Development Bank.

Pasquale Scaramozzino is a Professor of Economics at the Centre for Finan-

cial and Management Studies, SOAS, University of London. Professor

Scaramozzino has taught at the University of Bristol, at University College

London and at Università di Roma ‘Tor Vergata’. His research articles in

finance and in economics have been published in several academic journals,

including Applied Economics, Economica, The Economic Journal, Empirical

Economics, Journal of Comparative Economics, Journal of Development Economics,

Journal of Environmental Economics and Management, Journal of Industrial

Economics, Journal of Population Economics, The Manchester School, Metroeco-

nomica, Oxford Bulletin of Economics and Statistics, Oxford Economic Papers,

Oxford Review of Economic Policy and Structural Change and Economic Dynam-

ics. He has also published extensively in medical statistics. Professor

Scaramozzino has contributed to several CeFiMS modules, including Math-

ematics and Statistics for Economists, Portfolio Analysis and Derivatives,

Quantitative Methods for Financial Management, Managerial Economics, and Risk

Management: Principles and Applications.

Jonathan Simms is a tutor for CeFiMS, and has taught at University of

Manchester, University of Durham and University of London. Dr Simms has

contributed to development of various CeFiMS modules including Econo-

metric Principles & Data Analysis, Econometric Analysis & Applications,

Financial Econometrics, Risk Management: Principles & Applications, Public

Financial Management: Reporting and Audit, Banking Strategy, Introduction to

Law and to Finance, and Advanced Topics in Valuation.

3 Study Materials This Study Guide is your main learning resource for the module as it directs

your study through eight study units. Each unit has recommended reading

either from the textbooks or from supplementary readings which are includ-

ed in the Module Reader.

Textbook

Tim Koller, Marc Goedhart and David Wessels (2015) Valuation. Measuring

and Managing the Value of Companies, Sixth edition, Hoboken New Jersey:

John Wiley & Sons.

In addition, you will receive a Module Reader with articles from academic

journals and financial papers. You will be advised in the Study Guide when

to read these and what to focus on when reading from them.



4 Module Overview

Unit 1 Foundations of Value Creation 1.1 Introduction 1.2 Why Study ‘Value’? 1.3 Growth and Return on Invested Capital (ROIC) 1.4 The Maths of Value Creation 1.5 The Conservation of Value 1.6 Risk and Value Creation 1.7 Expectations and Why Shareholder Expectations Become a Treadmill 1.8 Decomposing total returns to shareholders 1.9 Conclusion

Unit 2 Sources of Value Creation 2.1 Introduction 2.2 Drivers of Return on Invested Capital 2.3 Competitive Advantage 2.4 The Sustainability of ROIC 2.5 Drivers of Revenue Growth 2.6 Growth and Value Creation 2.7 The Difficulty of Sustaining Growth 2.8 Conclusion

Unit 3 Framework and Organisation of Valuation 3.1 Introduction 3.2 Enterprise Discounted Cash Flow Model 3.3 Economic Profit Valuation Model 3.4 Adjusted Present Value Model 3.5 Reorganising the Accounting Statements 3.6 Conclusion

Unit 4 Performance Analysis 4.1 Introduction 4.2 Analysing ROIC 4.3 Analysing Growth 4.4 Credit Health and Capital Structure 4.5 Mechanics of Forecasting 4.6 Additional Issues regarding Forecasting 4.7 Continuing Value: DCF Valuation 4.8 Continuing Value: Economic-Profit Valuation 4.9 Common Pitfalls and Limitations of Forecasting 4.10 Conclusion

Unit 5 Cost of Capital and Value per Share 5.1 Introduction 5.2 Weighted Average Cost of Capital 5.3 Estimating the Cost of Equity 5.4 Estimating the After-Tax Cost of Debt 5.5 Using Target Weights to Determine the Cost of Capital



5.6 Valuing Non-Operating Assets 5.7 Valuing Debt and Debt Equivalents 5.8 Valuing Hybrid Securities 5.9 Conclusion

Unit 6 Reporting Results 6.1 Introduction 6.2 Verifying Results 6.3 Sensitivity Analysis 6.4 Creating Scenarios 6.5 Valuation by Parts 6.6 Using the Multiples 6.7 Using the Peer Group 6.8 Alternative Multiples 6.9 Conclusion

Unit 7 Market Value 7.1 Introduction 7.2 The Role of Economic Fundamentals 7.3 Market Valuation Levels – Return on Invested Capital and Growth 7.4 Expectations and Returns to Shareholders 7.5 Do Earnings Matter over Cash Flows? 7.6 Technical Trading Factors and Stock Market Values 7.7 Conclusions

Unit 8 Agents and Efficient Markets 8.1 Introduction 8.2 Company Mispricing 8.3 Market Mispricing 8.4 The Role of Investors 8.5 Further Challenges of Behavioural Finance 8.6 Market Efficiency – Managerial Implications 8.7 Conclusions 8.8 Module Summary – ‘What you have and have not studied’

Unit 1 introduces the foundations of value creation. You will learn how a

long-run perspective supports value creation for companies and the econo-

my. You will also study how the return on invested capital and growth rate

affect a company’s cash flow, and how the expectations treadmill affects

managers’ ability to deliver total returns to shareholders.

Unit 2 examines two drivers of value creation – the returns on invested

capital, and growth. In this unit you will study a detailed analysis of

returns on invested capital. The unit considers how the return on invested

capital is driven by corporate strategy and competition among firms in a

similar industry. You will also examine the importance of growth and

what determines the sustainability of growth across firms and industries.

Unit 3 introduces the core valuation techniques. You will examine a step-by-

step procedure for valuing a company. The unit discusses three valuation

techniques: enterprise discounted cash flow, discounted economic profit,



and adjusted present value method, and when to use them. The unit also

includes a consideration of how to reorganise the financial statements for an

analysis of economic performance.

In Unit 4 you will study how to analyse historical performance and identify

sources of value. You will learn the steps involved in analysing the return on

invested capital, revenue growth and financial health. The unit then focuses

on the mechanics of forecasting over an explicit forecast period, and estimat-

ing and interpreting continuing value.

Unit 5 discusses how to define the weighted average cost of capital (WACC)

so that it correctly measures the opportunity cost of investment. We describe

the components of WACC and discuss how to estimate the cost of equity,

cost of debt, and target capital structure. You will then learn how to estimate

enterprise value, equity value, and value per share, based on core operating

value and an understanding of capital structure.

Unit 6 illustrates ways of checking the robustness of the valuation methods.

It explains how to use key uncertainties that affect the company’s future to

construct a range of alternative forecasts using scenario analysis. The unit

also describes multiple analysis, where critical firm ratios – for example, the

ratio of enterprise value to next year’s projected EBITA (earnings before

interest, taxes and amortisation) are compared to those of similar firms to

identify differences in forecast performance.

Unit 7 discusses to what extent stock market valuations are related to

fundamental values both in the long run and in the short term. It also

explains how stock market valuation is related to measures of real value

creation, such as ROIC and growth, rather than to such indicators of cash

flows as earnings per share.

Unit 8 critically examines the view that stock markets are informationally

efficient. It analyses the empirical evidence on deviations of stock market

valuations from intrinsic values and considers alternative forms of market

mispricing, which could result in bubbles and bursts. It discusses the main

principles of behavioural finance and its managerial implications for

investors.

5 Learning Outcomes When you have completed your study of this module, you will be able to:

• discuss the importance of value to the performance of companies and economies, and differentiate between activities that create value and those that do not

• explain how to calculate the Return On Invested Capital (ROIC), why a high ROIC can be sustained by a competitive advantage, and the role of pricing advantages and cost advantages in value creation

• provide a proper assessment and organisation of financial statements

• analyse ROIC and revenue growth and assess the financial health of a company with respect to its ability to take on short-term and long-term projects



• construct forecasts for an explicit forecast period, and estimate continuing value

• denote the properties of WACC, how to estimate it, and alternative ways to calculate its components, and its limitations

• provide a verification of valuation results and sensitivity analysis which helps confirm the value drivers of a company under a broad set of conditions

• identify the economic fundamentals of value – the return on invested capital and expected revenue growth

• explain what is meant by behavioural finance, distinguish between informed investors and noise traders and discuss the main managerial implications of market efficiency.

6 Assessment Your performance on each module is assessed through two written assign-

ments and one examination. The assignments are written after Unit 4 and

Unit 8 of the module session. Please see the VLE for submission deadlines.

The examination is taken at a local examination centre in September/

October.

Preparing for assignments and exams

There is good advice on preparing for assignments and exams and writing

them in Chapter 8 of Studying at a Distance by Christine Talbot. We recom-

mend that you follow this advice.

The examinations you will sit are designed to evaluate your knowledge and

skills in the subjects you have studied: they are not designed to trick you. If

you have studied the module thoroughly, you will pass the exam.

Understanding assessment questions

Examination and assignment questions are set to test your knowledge and

skills. Sometimes a question will contain more than one part, each part

testing a different aspect of your skills and knowledge. You need to spot the

key words to know what is being asked of you. Here we categorise the types

of things that are asked for in assignments and exams, and the words used.

All the examples are from the Centre for Financial and Management Studies

examination papers and assignment questions.

Definitions

Some questions mainly require you to show that you have learned some concepts, by setting out their precise meanings. Such questions are likely to be preliminary and be supplemented by more analytical questions. Generally, ‘Pass marks’ are awarded if the answer only contains definitions. They will contain words such as:

Describe Contrast

Define Write notes on

Examine Outline Distinguish between What is meant by

Compare List



Reasoning

Other questions are designed to test your reasoning, by explaining cause and effect. Convincing explanations generally carry additional marks to basic definitions. They will include words such as:

Interpret Explain What conditions influence What are the consequences of What are the implications of

Judgement

Others ask you to make a judgement, perhaps of a policy or of a course of action. They will include words like:

Evaluate Critically examine Assess Do you agree that To what extent does

Calculation

Sometimes, you are asked to make a calculation, using a specified technique, where the question begins:

Use indifference curve analysis to Using any economic model you know Calculate the standard deviation Test whether

It is most likely that questions that ask you to make a calculation will also ask for an application of the result, or an interpretation.

Advice

Other questions ask you to provide advice in a particular situation. This applies to law questions and to policy papers where advice is asked in relation to a policy problem. Your advice should be based on relevant law, principles and evidence of what actions are likely to be effective. The questions may begin:

Advise Provide advice on Explain how you would advise

Critique

In many cases the question will include the word ‘critically’. This means that you are expected to look at the question from at least two points of view, offering a critique of each view and your judgement. You are expected to be critical of what you have read.

The questions may begin:

Critically analyse Critically consider Critically assess Critically discuss the argument that



Examine by argument

Questions that begin with ‘discuss’ are similar – they ask you to examine by argument, to debate and give reasons for and against a variety of options, for example

Discuss the advantages and disadvantages of Discuss this statement Discuss the view that Discuss the arguments and debates concerning

The grading scheme: Assignments The assignment questions contain fairly detailed guidance about what is

required. All assignments are marked using marking guidelines. When you

receive your grade it is accompanied by comments on your paper, including

advice about how you might improve, and any clarifications about matters

you may not have understood. These comments are designed to help you

master the subject and to improve your skills as you progress through your

programme.

Postgraduate assignment marking criteria

The marking criteria for your programme draws upon these minimum core

criteria, which are applicable to the assessment of all assignments:

• understanding of the subject

• utilisation of proper academic [or other] style (e.g. citation of references, or use of proper legal style for court reports, etc.)

• relevance of material selected and of the arguments proposed

• planning and organisation

• logical coherence

• critical evaluation

• comprehensiveness of research

• evidence of synthesis

• innovation/creativity/originality.

The language used must be of a sufficient standard to permit assessment of

these.

The guidelines below reflect the standards of work expected at postgraduate

level. All assessed work is marked by your Tutor or a member of academic

staff, and a sample is then moderated by another member of academic staff.

Any assignment may be made available to the external examiner(s).

80+ (Distinction). A mark of 80+ will fulfil the following criteria: • very significant ability to plan, organise and execute independently a

research project or coursework assignment

• very significant ability to evaluate literature and theory critically and make informed judgements

• very high levels of creativity, originality and independence of thought

• very significant ability to evaluate critically existing methodologies and suggest new approaches to current research or professional practice

• very significant ability to analyse data critically



• outstanding levels of accuracy, technical competence, organisation, expression.

70–79 (Distinction). A mark in the range 70–79 will fulfil the following criteria: • significant ability to plan, organise and execute independently a

research project or coursework assignment • clear evidence of wide and relevant reading, referencing and an

engagement with the conceptual issues • capacity to develop a sophisticated and intelligent argument • rigorous use and a sophisticated understanding of relevant source

materials, balancing appropriately between factual detail and key theoretical issues. Materials are evaluated directly and their assumptions and arguments challenged and/or appraised

• correct referencing • significant ability to analyse data critically • original thinking and a willingness to take risks.

60–69 (Merit). A mark in the 60–69 range will fulfil the following criteria: • ability to plan, organise and execute independently a research project

or coursework assignment • strong evidence of critical insight and thinking • a detailed understanding of the major factual and/or theoretical issues

and directly engages with the relevant literature on the topic • clear evidence of planning and appropriate choice of sources and

methodology with correct referencing • ability to analyse data critically • capacity to develop a focussed and clear argument and articulate

clearly and convincingly a sustained train of logical thought.

50–59 (Pass). A mark in the range 50–59 will fulfil the following criteria: • ability to plan, organise and execute a research project or coursework

assignment • a reasonable understanding of the major factual and/or theoretical

issues involved • evidence of some knowledge of the literature with correct referencing • ability to analyse data • examples of a clear train of thought or argument • the text is introduced and concludes appropriately.

40–49 (Fail). A Fail will be awarded in cases in which there is: • limited ability to plan, organise and execute a research project or

coursework assignment • some awareness and understanding of the literature and of factual or

theoretical issues, but with little development • limited ability to analyse data • incomplete referencing • limited ability to present a clear and coherent argument.



20–39 (Fail). A Fail will be awarded in cases in which there is: • very limited ability to plan, organise and execute a research project or

coursework assignment

• failure to develop a coherent argument that relates to the research project or assignment

• no engagement with the relevant literature or demonstrable knowledge of the key issues

• incomplete referencing

• clear conceptual or factual errors or misunderstandings

• only fragmentary evidence of critical thought or data analysis.

0–19 (Fail). A Fail will be awarded in cases in which there is: • no demonstrable ability to plan, organise and execute a research

project or coursework assignment

• little or no knowledge or understanding related to the research project or assignment

• little or no knowledge of the relevant literature

• major errors in referencing

• no evidence of critical thought or data analysis

• incoherent argument.

The grading scheme: Examinations The written examinations are ‘unseen’ (you will only see the paper in the

exam centre) and written by hand, over a three-hour period. We advise that

you practise writing exams in these conditions as part of your examination

preparation, as it is not something you would normally do.

You are not allowed to take in books or notes to the exam room. This means

that you need to revise thoroughly in preparation for each exam. This is

especially important if you have completed the module in the early part of

the year, or in a previous year.

Details of the general definitions of what is expected in order to obtain a

particular grade are shown below. These guidelines take account of the fact

that examination conditions are less conducive to polished work than the

conditions in which you write your assignments. Note that as the criteria of

each grade rises, it accumulates the elements of the grade below. Assign-

ments awarded better marks will therefore have become comprehensive in

both their depth of core skills and advanced skills.

Postgraduate unseen written examinations marking criteria

80+ (Distinction). A mark of 80+ will fulfil the following criteria: • very significant ability to evaluate literature and theory critically and

make informed judgements

• very high levels of creativity, originality and independence of thought

• outstanding levels of accuracy, technical competence, organisation, expression

• outstanding ability of synthesis under exam pressure.



70–79 (Distinction). A mark in the 70–79 range will fulfil the following criteria: • clear evidence of wide and relevant reading and an engagement with

the conceptual issues

• develops a sophisticated and intelligent argument

• rigorous use and a sophisticated understanding of relevant source materials, balancing appropriately between factual detail and key theoretical issues

• direct evaluation of materials and their assumptions and arguments challenged and/or appraised;

• original thinking and a willingness to take risks

• significant ability of synthesis under exam pressure.

60–69 (Merit). A mark in the 60–69 range will fulfil the following criteria: • strong evidence of critical insight and critical thinking

• a detailed understanding of the major factual and/or theoretical issues and directly engages with the relevant literature on the topic

• develops a focussed and clear argument and articulates clearly and convincingly a sustained train of logical thought

• clear evidence of planning and appropriate choice of sources and methodology, and ability of synthesis under exam pressure.

50–59 (Pass). A mark in the 50–59 range will fulfil the following criteria: • a reasonable understanding of the major factual and/or theoretical

issues involved

• evidence of planning and selection from appropriate sources

• some demonstrable knowledge of the literature

• the text shows, in places, examples of a clear train of thought or argument

• the text is introduced and concludes appropriately.

40–49 (Fail). A Fail will be awarded in cases in which: • there is some awareness and understanding of the factual or

theoretical issues, but with little development

• misunderstandings are evident

• there is some evidence of planning, although irrelevant/unrelated material or arguments are included.

20–39 (Fail). A Fail will be awarded in cases which: • fail to answer the question or to develop an argument that relates to

the question set

• do not engage with the relevant literature or demonstrate a knowledge of the key issues

• contain clear conceptual or factual errors or misunderstandings.

0–19 (Fail). A Fail will be awarded in cases which: • show no knowledge or understanding related to the question set

• show no evidence of critical thought or analysis

• contain short answers and incoherent argument. [2015–16: Learning & Teaching Quality Committee]



Specimen exam papers CeFiMS does not provide past papers or model answers to papers. Modules

are continuously updated, and past papers will not be a reliable guide to

current and future examinations. The specimen exam paper is designed to

be relevant and to reflect the exam that will be set on this module.

Your final examination will have the same structure and style and the range

of question will be comparable to those in the Specimen Exam. The number

of questions will be the same, but the wording and the requirements of each

question will be different.

Good luck on your final examination.

Further information Online you will find documentation and information on each year’s examina-

tion registration and administration process. If you still have questions, both

academics and administrators are available to answer queries.

The Regulations are also available at www.cefims.ac.uk/regulations/,

setting out the rules by which exams are governed.

DO NOT REMOVE THE QUESTION PAPER FROM THE EXAMINATION HALL

UNIVERSITY OF LONDON

CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES

MSc Examination MBA Examination Postgraduate Diploma Examination for External Students

91DFM C364

FINANCE (BANKING) FINANCE (FINANCIAL SECTOR MANAGEMENT) INTERNATIONAL BUSINESS ADMINISTRATION


Specimen Examination This is a specimen examination paper designed to show you the type of examination you will have at the end of the year for Introduction to Valuation. The number of questions and the structure of the examination will be the same but the wording and the requirements of each question will be different. Best wishes for success on your final examination. The examination must be completed in THREE hours. Answer THREE questions. The examiners give equal weight to each question; therefore, you are advised to distribute your time approximately equally between three questions.

PLEASE TURN OVER



Answer THREE questions. 1. Next year, Company A’s NOPLAT is £500 million, with a

growth rate of 3 percent, ROIC of 20 percent, and WACC of 10 percent.

a) Explain the value driver formula and calculate the

value of the company. b) Company B’s growth rate is 5%, ROIC is 12%, and

WACC is 10%. The corporate tax rate is 30%. Explain and calculate the value-to-EBITA ratio.

2. Given the following financial information

Source of Capital

Proportion of Total Capital

Cost of Capital

Marginal Tax Rate

After- tax Cost of Capital

Contribution to WACC

Equity 35% 10% ? ?

Debt 65% 5% 30% ? ?

WACC ? a) Complete the table. b) Discuss in relation to the valuation methods whether

the WACC can be assumed constant or not.

3. Given the following company statement, in £ millions:

Accountant’s income statement NOPLAT

Revenues 80.0) Revenues 80)

Operating costs (40).0 Operating costs (40)

Depreciation (16).0 Depreciation (16)

Operating profit 240) Operating profit 24)

Interest (1.6) Operating taxes ?

Non-operating income 0.4. NOPLAT ?

Earnings before taxes 22.8. After-tax non-operating income ?

Taxes ? Income available to investors ?

Net income ? a) Calculate the NOPLAT information. The marginal tax

rate is 30 percent. b) Discuss how you will assess whether the adjustments

are correct.

Specimen Examination


4. Discuss each of the following topics:

a) the advantages of ROIC in relation to ROE and ROA. b) the assumptions of a model in assessing the scenario

analysis. c) in the context of the CAPM, the index used to estimate

company beta; and the weights to use in WACC d) the investment incentives of intrinsic investors,

traders, and mechanical investors.

5. Complete the following table:

Values Year 1 Year 2 CV

Revenues £50 £52 £54

Operating costs

Operating margin

Operating taxes

NOPLAT

Net investment

Free cash flow

Discounted cash flow

Discount factor

DCF

Key value drivers:

Investment rate (net investment as a percentage of NOPLAT) = 40%, Growth rate = 4%, Operating costs as per cent of revenues = 70%, Operating taxes = 30%, NOPLAT margin (operating margin as per cent of revenues × [1 – tax rate]) = 21%, ROIC = 12%, Cost of capital = 10%.

a) Complete the table and calculate the value of opera-tions.

b) Do you think the firm’s value would increase if the explicit forecast horizon increases?

c) Discuss the assumptions involved in estimating contin-uing values.

PLEASE TURN OVER



6. A company has constant costs per unit of $2, no fixed costs and pays no taxes. Your forecasts suggest that in Year 1 sales will be 40 units, in Year 2 sales will be 44 units, and in Year 3 sales will be 48.4 units. Prices per unit (including inflation forecast) in Year 1 will be £10; in Year 2 will be £10.4; and in Year 3 will be £11.0. The capital invested is $4,000, with the rate of reinvestment equal to 50 percent of income. a) Calculate ROIC for Year 1, Year 2, and Year 3. b) Discuss whether the results are realistic. c) Explain how you will assess the sensitivity of your

results.

7. Critically discuss whether positive earnings announcements may lead to a higher valuation of a company. Does the varia-bility of earnings matter? Explain your answer.

8. What is meant by behavioural finance? Critically examine the

role of noise traders, and discuss under what conditions they could have a destabilising influence in stock markets.

[END OF EXAMINATION]


Unit 1 Foundations of Value Creation

Contents

Unit Content 2

Learning Outcomes 2

1.1 Introduction 3

1.2 Why Study ‘Value’? 3

1.3 Growth and Return on Invested Capital (ROIC) 5

1.4 The Maths of Value Creation 6

1.5 The Conservation of Value 12

1.6 Risk and Value Creation 16

1.7 Expectations and Why Shareholder Expectations Become a Treadmil l 20

1.8 Decomposing total returns to shareholders 21

1.9 Conclusion 24

References 26


2 Univers ity of London

Unit Content This unit introduces the foundations of value creation. You will learn how a

long-run perspective supports value creation for companies and the economy. You will also study how the return on invested capital and growth rate affect

a company’s cash flow, and how the expectations treadmill affects managers’ ability to deliver total returns to shareholders.

Learning Outcomes When you have completed your study of this unit and its readings, you will

be able to

• explain the importance of value to the performance of companies and economies, and differentiate between activities that create value and those that do not

• use the key value driver formula to obtain valuation estimates

• describe the managerial implications of value creation and how it is dependent on the relationship between the cost of capital and the return on invested capital (ROIC)

• explain the potential problems when a manager tries to meet high stock market expectation

• use the traditional and the enhanced approach to break down total returns to shareholders (TRS).

Reading for Unit 1

Textbook

Tim Koller, Marc Goedhart and David Wessels (2015) Valuation: Measuring and Managing the Value of Companies, Chapters 1 ‘Why Value Value?’, 2 ‘Fundamental Principles of Value Creation’, 3 ‘Conservation of Value and the Role of Risk’ and 4 ‘The Alchemy of Stock Market Performance’.

Course Reader

‘The value of share buybacks’ by Richard Dobbs and Werner Rehm (2005).


Centre for F inancial and Management Studies 3

1.1 Introduction In this course, we will provide a detailed consideration of the basic elements

and determination of corporate ‘value’. It is ‘value’ that should be the key driver in the corporate strategy as well as the market economy. So what is

‘value’?

Hypothetically, ‘value’ can take many forms and meanings. For our purpose,

let us focus on corporate strategy, and think of ‘value’ in terms of a broad and long-term concept – that is, ‘value’ as the positive factor that influences

all the stakeholders concerned, be they shareholders, investors, customers or employees. At a country or macro level, it may be our lack of a thorough

understanding and sufficient agreement on the fundamental sources of ‘value’ creation that leads to financial and economic crises.

For instance, could we confidently differentiate between a true value and, say, a bubble in the equity price of a corporation? By analysing value crea-

tion, can managers develop insight into what could be a new and long-term competitive advantage that would help their company to generate growth and

maintain returns on investment above their cost of capital? Value creation and valuation techniques are not, of course, simply about accounting terms to

beautify the balance sheet. By analysing value, and the sources of value creation, we can gain a greater understanding about how a company uses its

resources effectively and efficiently. Hence, our objective is to understand both the logic of value creation and the measurement of value in the most

sensible way possible.

Reading

For a brief introduction to the subject of valuation, please turn to your textbook by Koller et al., and study their first chapter.

1.2 Why Study ‘Value’? Why is it important to be able to obtain an accurate and realistic valuation of companies and of sectors? The significant cost of market bubbles and finan-

cial crises serve to remind us of the importance of good and proper valuation. This is not only about the financial cost, but also the real cost, including

unemployment and lost potential output and production when resources are misallocated. We can consider the internet bubbles of the 1990s that allowed

market capitalisation to increase disproportionately in relation to company’s actual revenue. One can argue that some of the increasing prices of corporate

stocks were justified in some cases, but definitely not all of them – or bubbles would not burst and eventually disappear in such a short period of time.

Tim Koller, Marc Goedhart and David Wessels (2015) Valuation: Measuring and Managing the Value of Companies, Chapter 1 ‘Why Value Value?’.



A popular justification of the internet bubbles is based on the economics of increasing return and network effects. These factors can allow companies

involved in technological and commercial innovation to expand quickly and profitably. However, these concepts cannot be applied to all products and

industries (e.g. grocery delivery, pet food, etc.) to rationalise the marked increase in company valuations that occur periodically.

We also need to be clear about activities that create value, activities that are neutral with respect to value, and activities that destroy value. To get an idea

how activities may or may not create value, we can consider the activities in financial institutions leading up to the financial crisis of 2007-08, and the

period of stagnation that followed. In brief, mortgage securitisation involved bundling up mortgage repayments (often on sub-prime mortgages), and

selling them as relatively risk-free securities to banks and other investors. The mortgage securitisation scheme collapsed because securitisation, fi-

nanced by availability of cheap short-term debt during the early 2000s, simply repackaged the risk associated with some spurious mortgages. While

securitisation is an ingenious financial innovation, it does nothing to increase cash flow – hence, there is no value creation. The subprime crisis is also a

vivid example of how an accounting technique that creates no value but mismatches short-term debts with long-term illiquid assets is a bad idea.

Ironically, the history of economic crisis tends to repeat itself, in the US (the 2000s), in Asia (the 1990s), and elsewhere. Of course, one cannot blame

everything on financial innovation. There are also the issues of how financial regulations have been enforced, or not, as well as our faith in the efficiency

of markets. We need to examine how investors value companies, to what extent do financial regulations increase the accuracy of financial reporting,

and are stock market valuations based on the fundamental drivers of value creation?

A focus on long-term value creation is essential. Having said that, there are many dimensions to measuring firm performance, e.g. governance and

employment conditions, as well as long-term shareholder value. But these dimensions are correlated – i.e. a focus on value creation reinforces employ-

ment standards, corporate governance and R&D investment. To create value, companies should pursue investments that boost revenue growth and return

on invested capital. Such a strategy rewards companies more than the pursuit of short-term objectives, such as accounting measures that boost earnings per

share, or cost reduction via R&D cuts, which could be harmful – or useless at least – in the long run. Understanding value creation requires a solid analysis

of the firm’s operations at a detailed level, to provide useful information that can help to sustain long-term company performance.

Study Quest ions

What do you think about changes in capital structure and changes in accounting practices introduced by a company manager? Do they support value creation?



What is the empirical relationship between earnings per share (EPS) and the value created by the acquisition of another company?

Do you agree with the view, expressed in your textbook, that criticism of sharehold-er capitalism can be interpreted as criticism of short-termism?

1.3 Growth and Return on Invested Capital (ROIC) We will now introduce discounted cash flow (DCF) valuation, a method that associates growth, cash flows, return on invested capital, cost of capital and

value. This is a powerful method, but it is also important that you are aware of the advantages and disadvantages of using DCF to value companies. As

you learn this method, you will see that accounting earnings are not exactly the same as value. You will also discover that the variables used in DCF can

vary significantly across firms within the same industry. Therefore it is essential to develop an understanding of the specific circumstances of a

company to perform the valuation analysis, while also making comparisons between companies in the same sector. Using DCF you will be able to see

how two firms with the same earnings and growth rate can be valued differ-ently if one company has a higher return on invested capital than the other

company. Similarly, you will see how two companies can generate similar rates of total shareholder return, but one company has higher growth while

the other company has higher return on invested capital.

In the DCF method, the relationship between growth, return on invested

capital, and investment rate can be succinctly summarised as

Return on invested capital = Growth / Investment rate

so that in comparing two companies with the same growth, the one with the lower investment rate tends to generate more cash flows, higher return

on invested capital, and higher price/earnings (P/E) ratio.

The next reading from your textbook highlights this relationship between

growth, return on invested capital, and cash flow. The reading demon-strates some deceptively simple but fundamental points in the

construction of the DCF model.

Suppose there are two companies with identical earnings and the same

growth rate of earnings. But also suppose that one company requires less investment to generate their earnings growth. This company will have a

higher return on invested capital. And cash flow (defined in this simple example as earnings less new investment) will be higher for this compa-

ny, leading to a higher valuation.

The essential point being made is that it is insufficient to focus only on

earnings growth. Growth in revenues and earnings will only create value if the return on invested capital is greater than the cost of capital.



Reading

Please turn now to your textbook by Koller et al., and read pages 17–29, up to the section headed ‘The Math of Value Creation’.

In your notes on the reading, pay particular attention to the example of two companies presented in exhibits 2.2–2.4, with identical earnings and growth of earnings, but different investment rates, cash flows and valuations. Exhibit 2.5 shows the relation between growth, ROIC and value, based on a different numerical example.

Consider the relation between growth, ROIC and value shown in Exhibit 2.5. Looking across a row of the table, for a given growth rate a higher return on

invested capital leads to higher value. Now consider reading down the columns in Exhibit 2.5:

• If ROIC is greater than the cost of capital, then higher rates of growth lead to higher value.

• If ROIC is the same as the cost of capital, then higher growth leaves value unchanged.

• And if ROIC is lower than the cost of capital, higher growth in fact leads to lower value.

To some extent, equity prices observed in the stock market follow this simple valuation analysis. Markets tend to value favourably companies with a high

return on invested capital. This valuation principle is not only useful at the company level, but it is also applicable at the sector level, and even country

level. But one should not generalise too far.

As a general strategic guideline based on this formulation, for a low or

moderate ROIC company, focusing on ROIC improvement creates more value than single-mindedly accelerating only the revenue growth. For an

already high ROIC company, increasing growth is a natural objective, because it is harder to create value by trying to improve an already high

ROIC. Where a company has achieved a high ROIC, it is also important to understand that not all growth, and its corresponding investment, has the

same potential for value creation. For example, think about growth based on new product development vis-à-vis growth based on acquisition. An acquisi-

tion strategy tends to demand more investment and capital upfront, and has therefore a lower potential for value creation. Can you think of a growth

strategy that will boost ROIC in the long term?

1.4 The Maths of Value Creation To connect the concept of value creation explained so far with a more practi-cal analysis based on company financial statements, let us start by looking at

some simple formulas. These terminologies and variables will be recurring throughout the units, so you will find it useful to try to understand them at

Tim Koller, Marc Goedhart and David Wessels (2015) Valuation: Measuring and Managing the Value of Companies, beginning of Chapter 2 ‘Fundamental Principles of Value Creation’.



this stage. The important variables involved are summarised as follows, with more detailed explanation provided in the next reading.

• NOPLAT: Net Operating Profit Less Adjusted Taxes

• Invested Capital: mainly property, plant, equipment, and working capital.

The two definitions given above relate to the core operations of the company.

• Net Investment is the increase in invested capital from one period to the next:

Net investment = Invested capitalt+1− Invested capitalt (1.1)

• Free cash flow is defined as NOPLAT less net investment

FCF = NOPLAT − Net investment (1.2)

• Return on invested capital is net operating profit from operations expressed in relation to invested capital:

ROIC = NOPLAT

Invested Capital (1.3)

• Investment rate:

IR = Net Investment

NOPLAT (1.4)

• WACC: Weighted Average Cost of Capital

WACC is also the discount rate used to discount future projections of FCF.

• g: A constant rate of growth of NOPLAT (and also FCF )

For cash flows growing at the rate g, and cost of capital WACC, we can use the cash flow perpetuity formula to estimate value

Value =

FCFt=1

WACC − g (1.5)

This perpetuity formula tells us the value of a stream of payments starting

one period from now, where the payments are growing at the rate g.

Free cash flow can also be defined in terms of NOPLAT and the investment

rate:

FCF = NOPLAT − Net Investment = NOPLAT − NOPLAT × IR( ) = NOPLAT 1− IR( )

(1.6)

As you have already seen, the investment rate can be expressed in terms of g

and ROIC:

g = ROIC × IR so IR = g

ROIC (1.7)



It follows that:

FCF = NOPLAT 1− g

ROIC⎛⎝⎜

⎞⎠⎟

(1.8)

Using the expression for FCF in (1.8), and the valuation of a growing perpe-

tuity in (1.5), the key value driver formula is obtained as:

Value =

NOPLATt=11− g

ROIC⎛⎝⎜

⎞⎠⎟

WACC − g (1.9)

The value driver formula in (1.9) relates the key variables in the DCF ap-

proach of valuation, which you will study in more detail. As you can now see, based on the DCF analysis, the value creation of a company is about

improving growth, returns on invested capital, and the relation of ROIC to the cost of capital. The relationship between value and these variables is non-

linear. In practical applications, each of the variables involved will be subject to uncertainty and measurement errors. While DCF analysis is not without

problems, it is quite straightforward and more transparent than other ap-proaches, as you will appreciate after studying the materials in this course.

You could now derive the price to earnings (P/E) ratio by dividing each side of (1.9) by NOPLAT:

ValueNOPLATt=1

=1− g

ROIC⎛⎝⎜

⎞⎠⎟

WACC − g (1.10)

The P/E ratio is a popular and much-reported measure. Looking at equation (1.10) you can see how the ratio can be related to the elements driving value

in the DCF analysis.

Reading

Please now turn to your textbook by Koller et al., and study pages 29–33 (to the end of the chapter), paying particular attention to the interpretation of the variables.

While studying the key value driver formula and the other expressions, you

may notice that they are based on some strong assumptions about the future values of the variables. The growth rate, return on invested capital, and cost

of capital (and by implication, the capital structure and the balance between debt and equity) are assumed to be constant.

It is possible to estimate value using the key driver formula in equation (1.9). However, in many applications we would want to allow the elements driving

value to vary from year to year. As you will see in later units, DCF involves making explicit annual forecasts for FCF in future years, but after this

explicit forecast period we stop forecasting FCF for each year, we assume a constant growth rate and we use the continuing value formula represented in

Tim Koller, Marc Goedhart and David Wessels (2015) Valuation: Measuring and Managing the Value of Companies, Chapter 2 ‘Fundamental Principles of Value Creation’, the section ‘The Math of Value Creation’.



equation (1.9). The maths of value creation introduced here encourages you to focus on the fundamental sources of value creation. You may be wonder-

ing how this approach can be extended to allow for risk and uncertainty; these issues will be studied in Units 4–6.

Study Quest ions

How does the association between growth and value depend on the relationship between ROIC and the cost of capital?

Do you think the core valuation principle is as equally applicable to countries as it is to companies?

We can now apply the maths of value creation to value the two companies

introduced in the reading from the textbook. Recall that both companies have earnings in year 1 of 100, and projected earnings growth of 5% per year; and

the cost of capital for both companies is 10%. Volume Inc. has an investment rate of 50% and Value Inc. has an investment rate of 25%.

Review quest ion

Estimate value for both companies using the key value driver formula.

Volume Inc. has the higher investment rate, and return on invested capital is equal to 10%:

ROIC = g

IR= 0.05

0.50= 0.10

Using the key value driver formula, the estimated value for Volume Inc. is

1,000:

Value =

NOPLATt=11− g

ROIC⎛⎝⎜

⎞⎠⎟

WACC − g=

100 1− 0.05

0.10

⎛⎝⎜

⎞⎠⎟

0.10− 0.05= 1000

Value Inc. has a lower investment rate and correspondingly a higher ROIC

equal to 20%:

ROIC = g

IR= 0.05

0.25= 0.20

The value estimated by the key value driver formula for Value Inc. is 1,500:

1

0.051 100 1

0.201500

0.10 0.05

tgNOPLAT

ROICValueWACC g

=⎛ ⎞ ⎛ ⎞− −⎜ ⎟ ⎜ ⎟⎝ ⎠ ⎝ ⎠= = =− −

Equivalently we could have used the growing perpetuity valuation formula,

which for Volume Inc. provides value of



Value =

FCFt=1

WACC − g= 50

0.10− 0.05= 1000

and for Value Inc.,

Value =

FCFt=1

WACC − g= 75

0.10− 0.05= 1500

You can see that the key value driver formula is based on the valuation formula for a growing perpetuity. However, the key value driver formula provides more

information concerning the sources of value creation in each company.

Finally in this section you should make sure you understand how the key

value driver formula introduced in this unit is used in the valuation process. For the two companies Volume Inc. and Value Inc. we have assumed the

growth rate is constant for year 1 onwards. In this case it is possible to use only the key value driver formula to value the companies.

In more realistic situations it is likely that the forecast growth rate for a company will not be the same in every year. In this case we make explicit

annual forecasts for a number of years, and then after this explicit forecast period we make an assumption about the growth rate into perpetuity, and we

apply the key value driver formula to estimate continuing value. Note that this estimate of continuing value (CV) would need to be discounted back to

the time of the valuation.

For example, the values obtained in Exhibit 2.5 in your textbook are obtained

using an explicit forecast period of 15 years (applying the growth rates of 3%, 6% and 9% for the explicit forecast period), and after 15 years the

growth rate is assumed to be 4.5%.

In the next review question you will examine an Excel workbook that puts

this all together. You will study the more detailed mechanics of valuation in the following units, including discounting, making forecasts, and reorganis-

ing financial reports to obtain estimates of NOPLAT. For the moment it will be useful to see how we forecast and discount cash flow using an explicit

forecast period and then continuing value, and how the key value driver relates to those forecasts, using a simplified example.

Review quest ion

The Excel workbook C364_U1_Q1.xls conducts a valuation with an explicit forecast period of 15 years. After that time the continuing value formula (key value driver formula) is used.

1. Please examine the entries in the workbook, including how the future projec-tions of earnings and free cash flow are obtained in the explicit forecast period; how projections of cash flow are discounted in the explicit forecast period, and how the continuing value formula is used for year 16 and onwards.

2. Vary the investment rate and examine the effect on the calculations (try the values of 0.50 for Volume Inc. and 0.25 for Value Inc.).



3. As a checking mechanism, the workbook also estimates the valuation using on-ly the key value driver formula. In the workbook the valuation using an explicit forecast period of 15 years (and continuing value from year 16 onwards) gives the same value as when we use the CV formula for all projected free cash flow. Why is that?

In this case we have assumed a growth rate of earnings and a given invest-

ment rate. From this the ROIC is implied. (Recall equation (1.7) relating the growth rate, IR and ROIC).

In the explicit forecast period we obtain a forecast of earnings each year as earnings in the previous year multiplied by one plus the growth rate. Invest-

ment is calculated as earnings multiplied by the investment rate. Free cash flow is earnings less investment.

The forecast cash flow in each year is discounted using the discount factor for that year, which is equal to

Discount factor = 1

1+WACC( )t (1.11)

In words, the discount factor for each year is the reciprocal of 1 plus the

WACC raised to the power of the number of years ahead of the forecast.

For the continuing value (CV) estimated in year 16 we take the earnings in

year 15, we apply the growth rate to get forecast earnings in year 16, and then we use this value of earnings in the key value driver formula. We then

discount this estimate of CV using the same discount factor we used for year 15.

The estimate of value is the sum of the discounted cash flows for each of the years in the explicit forecast period, plus the discounted CV obtained for

years 16 and beyond:

Value =FCF

1

1+WACC( )1+…+

FCF15

1+WACC( )15+ CV

1+WACC( )15 (1.12)

In this example the value we obtain using an explicit forecast period (years 1

to 15) followed by a period of constant growth (year 16 and beyond) is the same as the value we obtain using the CV formula for all of the years. This is

because we have assumed a constant growth rate throughout. We could have an explicit forecast period of 5, 10, 15 or 20 years, followed by the CV

formula, and this equality would still hold. If the key value drivers are the same in each year, we can value the company using an explicit forecast

period of any length, or we can just use the key value driver formula.



1.5 The Conservation of Value Please pause for a moment and consider what you have studied so far in this

unit. The value of a firm is derived from the discounted cash flow from operations. Value is created if cash flow can be increased. Growth creates

value as long as the return on invested capital is greater than the cost of capital. (If ROIC is less than the cost of capital then growth destroys value.)

Therefore strategies that contribute to growth (subject to the ROIC being greater than the WACC), or increase ROIC, or reduce WACC, will increase

value.

From this understanding of value it follows that strategies which appear (or

can be made to appear) to create value, but which do not increase cash flow by one or more of the above channels, will not actually increase value (and

will leave value the same). This is the principle of value conservation. Another way of looking at the principle of value conservation is to say that

anything that appears to change value, but which does not actually increase or decrease cash flow, will leave value unchanged and is value neutral.

Reporting employee stock options

To demonstrate the conservation of value (or value neutrality) we can use the

example of how companies report employee stock options. An employee stock option is ‘a call option issued by a company on its own stock and given

to an employee as part of his or her compensation’ (Hull, 2014: 572), and a call option gives the holder the right (but not the obligation) to buy the stock

at a certain price by a certain date. If an employee exercises their right to buy the stock, this has the effect of diluting the shareholdings of existing share-

holders, and reduces cash flow to existing shareholders. In effect, giving stock options to employees reduces value available to existing shareholders.

Review Quest ion

Suppose a company previously reported employee stock options in the footnotes to its financial reports. Now suppose the company changes its reporting methods and includes employee stock options as an expense on the income statement. Will this change in reporting affect the value of the company?

If information about employee stock options is already made available, then

changing the way the stock options are reported will not affect cash flow and will not change the value of the company. Employee stock options them-

selves do change value available to existing shareholders (by diluting cash flow to shareholders) but the way the employee stock options are reported

does not.

Debt and equity restructuring

Does restructuring the debt and equity of a company create value? Capital restructuring will only affect the value of a company if it changes the cash



flows. Otherwise, it will leave the value of the company unchanged. In later units you will see that increasing debt can potentially increase value. Debt

finance creates a tax shield (debt interest is deducted before corporation tax is calculated). However, increasing debt and reducing equity changes the

riskiness of the company for investors, and alters the weighted cost of capital. In theory, the combined effect of the increased tax shield and the changed

WACC should leave the value of the firm (which derives from the discounted cash flow from operations) unchanged.

At this stage we can make two general points about the conservation of value. Firstly, the DCF method makes clear that unless a change alters cash

flow, the change will not alter the valuation. Secondly, stock markets also understand the logic of the conservation of value.

In the following sections you will consider a number of additional corporate actions that are perceived to create value, and examine the effect, if any, on

company valuation:

• share repurchases

• acquisitions

• financial engineering.

1.5.1 Share repurchases

Companies engage in share repurchases for a number of reasons. Companies

may prefer to use this method of returning cash to investors instead of paying dividends. This could be due to different tax treatment for investors between

dividends and capital gains. Alternatively, the company may prefer the flexibility of share repurchases: once dividend payments have been estab-

lished, and an expectation has been created concerning regular dividend payments, if dividends are then stopped it could be interpreted negatively.

Companies also engage in share repurchases because it increases crude measures of earnings per share, and gives the impression of creating value.

However, as you saw earlier in this section, changing capital structure cannot create value for the company unless it also increases cash flow.

Reading/podcast

Please now read the article by Dobbs and Reim ‘The value of share buybacks’. The article provides a useful application of the methods you have studied so far in this unit. It shows how the value of the company derives from the value of operations, and the circumstanc-es when share buybacks do (and do not) create value. The reading also provides an example of when the spread between ROIC and WACC is negative.

The reading is also available as a podcast, at http://www.mckinsey.com/insights/corporate_finance/the_value_of_share_buybacks

Examining Exhibit 1 in the article, share repurchases do increase earnings per share: interest income on excess cash holdings is lost, but shares outstanding

fall proportionately more. However, the value of operations is unchanged.

Dobbs, Richard and Werner Rehm (2005) ‘The value of share buybacks’, McKinsey Quarterly, August, http://www.mckinsey.com/insights/corporate_finance/the_value_of_share_buybacks



Total value is reduced by the cash used to purchase the shares, but with less shares outstanding, the share price is the same.

Review quest ion

With respect to Exhibit 1 in the article by Dobbs and Reim, confirm that

1. ROIC is 16% before and after the share buyback; and 2. Value from operations is 1,300.

ROIC in this example is calculated as earnings before interest and taxes as a percentage of operating assets, or

ROIC = 94

580= 0.162

Using the continuing value formula, value from operations is estimated as

Value =

NOPLATt=11− g

ROIC⎛⎝⎜

⎞⎠⎟

WACC − g=

94 1− 0.05

0.162

⎛⎝⎜

⎞⎠⎟

0.10− 0.05= 1,300

Optional reading

You may wish to read an empirical examination of share repurchases and the impact on company valuation by Gustavo Grullon and Roni Michaely (2002) ‘Dividends, share repurchases, and the substitution hypothesis’. However, this is an optional reading.

1.5.2 Acquisit ions

Acquisitions can potentially create value for the combined companies.

However, this will only be the case if the acquisition increases the cash flows of the combined companies. An acquisition could lead to synergies between

the combined companies such that new products can be developed leading to new revenue streams, for the same (combined) invested capital. ROIC

increases and value is created. Or costs that were duplicated in the two companies could be reduced, again increasing ROIC.

However, if cash flows are unchanged after the acquisition, the value of the combined companies will be just the same as the value of the two companies

separately. The acquisition has not created value. Having said that, it is possible for managers to believe the acquisition has created value if they

ignore the conservation of value principle. Taking the example from your textbook, suppose Company A is valued at $100 and company B is valued at

$50. Company A is expected to earn $5 so has a P/E ratio of 20. Company B is expected to earn $3 so has a P/E ratio of 16.7. Suppose the acquisition does

not increase cash flows and does not create value. With unchanged value and unchanged earnings the P/E ratio of the combined company will be



100+50

5+ 3= 18.75

What will be the effect on the P/E of the combined company if the earnings

of company B, after the acquisition, are thought to be as highly valued as the earnings of company A. Applying Company A’s P/E ratio of 20 to Company

B’s earnings of 3 gives a value of B of 60. By magic, the value of the com-bined company is 160 and not 100 plus 50. The perception that the

acquisition creates value (even when it does not) arises because managers have assumed the earnings of Company B will be more highly valued be-

cause of the acquisition.

The valuation of acquisitions is studied in detail in the module Advanced Topics in Valuation. For this unit you need to be aware how the conservation of value principle applies to acquisitions: acquisitions will only create value

if the acquisition leads to increased cash flows for the combined company. If cash flows are not changed, then the value of the combined company is just

the sum of the value of the two companies considered separately.

1.5.3 F inancial engineering

The authors of your textbook define financial engineering as the use of

financial instruments or structures other than straight debt and equity to manage a company’s capital structure and risk profile. This can include

derivatives, structured debt, securitisation, and off-balance sheet financing. Managers and investors should be aware that some examples of financial

engineering can create value for the company, and some do not create value.

Financial engineering can create value if it results in tax savings or lower

funding costs, or if it allows the company to expand its funding and under-take more investments that generate wealth. Conversely, some elements of

financial engineering that appear to create value may be value-neutral or may destroy value.

We can consider how taking assets (and the associated financing) off the balance sheet can enhance value or be value-neutral. The example presented

in your textbook concerns US hotel companies that do not own their hotels. The hotels are actually owned by partnerships or real estate investment trusts.

Because these partnerships and trusts are taxed differently to corporations, this example of financial engineering reduces tax payments for the hotel

companies and increases value.

Alternatively, consider a company that sells and then leases back its operat-

ing assets. It is possible that this off-balance-sheet financing can appear to increase value. Lease expenses reduce NOPLAT, but the company will

appear to be less capital intensive, and return on invested capital can appear to be higher. Such an arrangement may or may not increase value. The lease

expense will include an element of interest. If the company itself has a lower cost of borrowing than the leasing company, then the sale and lease back

could destroy value.



These are relatively simple examples of financial engineering. As the type of instruments used gets more complex, there is further scope for managers to

misunderstand the effects on valuation. At best, the instruments may be value neutral, and at worst they could destroy value if they are not understood

correctly.

Reading

Please now turn to your textbook by Koller et al., and read pages 35–42, from the section ‘Conservation of Value’ up to ‘Risk and Value Creation’.

Please note the examples of acquisitions that do create value. And also the exam-ples of financial engineering where value is created or left unchanged.

Study Quest ions

How might the following forms of financial engineering create value?

1. A vehicle manufacturer securitises its accounts receivable by selling them to a fully owned but separate company

2. An airline company transfers the risk of sudden increases in fuel prices to a finan-cial institution specialised in hedging.

In the first case, receivables are a good source of collateral, so that the subsidiary could be able to get a better credit rating than the vehicle manufac-

turer. In effect, the combined company could expand its debt more than would have been the case without the arrangement, which would increase

value if investments exist for which ROIC is greater than WACC. This strategy has been followed by Ford and General Motors.

In the second case, the hedging company would have a comparative ad-vantage in hedging compared to the airline company, and could carry these

risks at a lower cost.

1.6 Risk and Value Creation Risk affects valuation via the cost of capital and future cash flows. As you will

see in this section, managers need to be more concerned about the risks associ-ated with future cash flows than with how risk affects the cost of capital.

Cost of capital

You will examine the methods used to determine the company’s cost of capital

in detail in Unit 5. In this section we will introduce what the cost of capital represents, and why risk and the cost of capital is of less concern to managers

than the risks concerning future cash flows. For investors, the cost of capital represents the return they require to compensate them for the risks associated

with investing in a company. When investors make decisions about their portfolios of securities, they consider diversifiable and non-diversifiable risk.

Tim Koller, Marc Goedhart and David Wessels (2015) Valuation: Measuring and Managing the Value of Companies, Chapter 3 ‘Conservation of Value And The Role Of Risk’, sections cited.



Some risk can be diversified. Investors choose a portfolio of securities for which the returns are negatively or imperfectly correlated – for two negative-

ly correlated returns, when the returns on one security go down, the returns on the other security go up. So, for example, an investor might buy stocks in

a producer of aviation fuel and a user of aviation fuel. Diversification allows investors to reduce the risk of their overall portfolio, for a given expected

return on the portfolio. However, some risks cannot be diversified, such as risks due to economic downturns that affect all companies within an econo-

my. It is this non-diversifiable risk that investors are being compensated for by the cost of capital. Since the activities of one company represent a diversi-

fiable risk, the cost of capital is more a reflection of non-diversifiable risk. Put another way, most risks faced by companies are diversifiable and will not

affect their cost of capital.

You should be aware, however, that management decisions concerning debt

and equity can affect investor perceptions of the riskiness of the company, and this has an influence on the company’s cost of capital. You will revisit

this relationship at various points in your study of valuation.

The authors of your textbook find that for large companies the cost of equity

capital varies in a narrow range of 8 to 10 per cent. We can use the results from the maths of value creation to put that into context.

The key value driver formula is

Value =

NOPLATt=11− g

ROIC⎛⎝⎜

⎞⎠⎟

WACC − g (1.9)

The authors of your textbook observe returns on invested capital in the much wider range of less than 5% to more than 30%, sometimes in the same sector.

The conclusion from this observation is that whether WACC is 9% or 10% matters less than the ROIC that is achieved.

You can also use the maths of value creation to examine the influence on price/earnings ratios of the key value drivers, shown in equation (1.10)

ValueNOPLATt=1

=1− g

ROIC⎛⎝⎜

⎞⎠⎟

WACC − g (1.10)

The P/E ratios for large companies also fall in a relatively narrow range, between 12 and 20. This range is consistent with the narrow range of the cost

of capital between 8 and 10 per cent.

Review quest ion

In the context of equation (1.10) representing the price/earnings ratio, what would happen to the P/E range for large companies if the range of the cost of capital was 6 to 15 per cent (and not 8 to 10 per cent).



The P/E ratio varies inversely with the WACC (if everything else is un-changed): higher WACC reduces P/E. If the lower end of the range of the

WACC (8%) is associated with the higher end of the P/E range (20%), then a WACC of 6% would be associated with a P/E of more than 25. Conversely,

if a WACC at the higher end of the range (10%) is associated with the lower end of the observed P/E range (12), then a WACC of 15% is associated with

a P/E ratio of around 8. (Note these are approximate calculations.) The point to take from this is that if the WACC faced by large companies was in a

wider range than 8 to 10 per cent then we would observe a wider range of P/E ratios.

We conclude that managers should not be too concerned with how operational risks affect the cost of capital, because most risks they face do not generally

affect their cost of capital, and the range of the cost of capital is relatively small compared to the ranges of the other value drivers. Instead, managers

should be more concerned with the risks associated with future cash flows.

Cash f low risk

Cash flow risk represents the possibility that actual future cash flows will be less than projected future cash flows. The traditional method for analysing

this type of risk is to make at least two types of forecast. For example, a ‘normal’ or ‘optimistic’ scenario and a ‘pessimistic’ scenario, and to attach a

probability of the scenarios occurring. In this way we can weight cash flows in the two scenarios by the two probabilities, and we can calculate expected

cash flow each year, and expected discounted cash flow. Subtracting the initial investment produces a figure for expected net present value for a

project. The traditional decision rule is that we should pursue projects that have positive expected net present value. You will use this technique to

conduct scenario analysis in Unit 6 Reporting Results.

Review quest ion

Can you see any problems with this method of forecasting cash flows under different scenarios, assigning probabilities, weighting the cash flows, and calculating expected net present value?

This method produces one figure for expected net present value, which dis-

guises the net present value we would experience if the good outcome occurred, and the net present value we would experience if the bad outcome

occurred. Suppose the losses under a pessimistic scenario were so great that they bankrupted the company, but that the potential gains under the good

outcome were so high that the expected net present value (calculated using the probabilities of occurrence) was positive. Would you still pursue the project?

To answer this type of question we need to examine the projected cash flows under both scenarios. The risks associated with the cash flows should be

incorporated into the cash flow projections (for different scenarios). These detailed projections provide the opportunity to analyse risks that might affect



future cash flows, to decide whether to undertake projects, and also to examine the knock-on impacts not only for the valuation but also on other

operations and the viability of the company.

You will examine scenario analysis in Unit 6. A more detailed study of the

methods available to analyse the impact of flexibility on value, including decision-tree analysis and real options pricing, is provided in the module

Advanced Topics in Valuation.

The next reading from your textbook includes a simple example of scenario

analysis to demonstrate how we can analyse cash flow risk. It also consid-ers whether and in what circumstances companies should hedge their cash

flow risks.

Reading

Please now turn to your textbook by Koller et al., and read pages 42–47, ‘Risk and Value Creation’.

Please make sure you understand the advantages and disadvantages of using hedging to reduce the risk associated with future cash flows.

Review quest ion

A company is considering undertaking a project. The outcome of this project has two possibilities

1 70% probability that it is worth 100 million USD 2 30% probability that it is worth nothing and bankrupts the company

Should the company undertake this project? Suppose first that, as a CEO of this company, you are risk-neutral (i.e. your decision is based on the expected payoff).

Next, suppose instead that you are a risk-averse CEO.

Note briefly your views on these possibilities.

In general, hedging should reduce the volatility of the company’s cash flows.

However, a decision to hedge (or not) is not just an accounting consideration. For instance, if mining companies were to hedge their revenue, this would

add complexity to the portfolio management of the investors who, after all, are investing in the first place because they want exposure to volatile com-

modity prices.

Yet, there are some risks that a company may want to hedge in any case.

Currency risk is especially important to exporting companies. Because revenues and costs are not in the same currency, changes in exchange rates

between the home and foreign markets influences operating margins.

A company in emerging markets may be more exposed to currency risk,

because the home market currency tends to be more volatile than the curren-cy of developed markets. Hedging choices also depend on the availability of

hedging instruments that a company can access i.e. forward contracts, op-

Tim Koller, Marc Goedhart and David Wessels (2015) Valuation: Measuring and Managing the Value of Companies, Chapter 3 ‘Conservation of Value and the Role of Risk’, the section on risk.



tions, futures and swaps. More in-depth treatment of hedging cash flows can be found in the module Risk Management: Principles and Applications.

1.7 Expectations and Why Shareholder Expectations Become a Treadmil l Over the long run (i.e. more than 10 years), the performance of management

and that of a company could be aligned and captured by the gains in share price plus dividend, known as the Total Return to Shareholders (TRS).

However, improving the expected overall performance, or an ‘expectation treadmill’ measured by TRS, may be more difficult for an already successful

business. For a mature or high performance company, it may seem that there is not much room for further growth to keep up with the past performance. In

addition, if one looks at a snapshot of TRS, it is likely to be too rudimentary to provide further insight into long-term performance; there are many other

factors affecting the share price – such as market sentiments, bubbles and irrationalities, among others. So at times, there might be a mismatch between

a rather short-term measure such as the traditional TRS and long-term value creation. What we need to consider is a decomposition of TRS into the key

drivers of value creation – growth and ROIC.

The starting point for understanding the expectations treadmill, or the work-

ing of TRS, is to recall that, at any given level of earnings, the existing shareholders and prospective shareholders would have different rates of

return in mind, depending on the prices paid for their shares. To maintain a good performance, and to push for even higher share prices, the expectations

treadmill would have to run ever faster – it becomes more difficult to meet market expectations, and even more so for companies with high performance

expectations. To maintain a high TRS above its peers in the industry, the manager may be tempted to boost the short-run TRS by carrying out projects

or investments that could be unproductive in the long run. Focusing too narrowly on the expectation of the markets, the company may become short-

sighted in terms of its investment choices.

Reading

Please now turn to your textbook by Koller et al., and read the beginning of Chapter 4, pages 49–54.

In your notes on the reading, focus particularly on the real-world effects of the expectations treadmill on Reckitt Benckiser in Exhibit 4.1.

Tim Koller, Marc Goedhart and David Wessels (2015) Valuation: Measuring and Managing the Value of Companies, Chapter 4 ‘The Alchemy of Stock Market Performance’.



1.8 Decomposing Total Returns to Shareholders To avoid the expectations trap, we should try to understand further the

company performance by decomposing TRS into the key value drivers. The decomposition should help us to discover the sources of change in TRS. Such

a decomposition should also inform expectations concerning performance so they are more consistent with the concept of value-creation discussed so far.

We start with the traditional approach to TRS decomposition. TRS equals the dividend yield plus the percentage change in share price. The percentage

change in share price can be decomposed into the percentage change in earnings plus the percentage change in the P/E:

TRS = Dividend Yield + %Δ(Share Price) = Dividend Yield + %Δ(Earnings) + %Δ(P/E) (1.13)

This traditional approach is quite problematic. First, recall that not all earn-ings growth has the same potential for value creation (e.g. new product vis-à-

vis acquisition). Second, we can see in this formulation that increasing dividends, while increasing TRS, may negatively affect the available cash

flow for future investment. Third, this traditional TRS decomposition does not take into account risk associated with leverage, i.e. debt/equity ratios.

Instead, we should decompose TRS into five components, as follows:

1 The value created by revenue growth, net of invested capital

2 The impact of profit margin improvements

3 What TRS would have been without the growth measured in part 1 and the improvement to profit margins in part 2

4 The change in P/E that reflects changes in shareholders’ expectations

5 The effect of the debt/equity ratio on TRS.

The first and second components are really the TRS from performance improvements; whereas the third and the fourth components can be consid-

ered as a temporary boost to the TRS; a high level of the fifth component is associated with greater risk.

Reading

Please now turn to your textbook by Koller et al., and study pages 54–63, the remainder of Chapter 4.

Check that you understand and can explain the TRS decomposition in the theoretical example in Exhibits 4.4 and 4.6, and the example of Reckitt Benckiser and Henkel in Exhibit 4.7.

Consider the example in Exhibit 4.4. TRS is the percentage change in the

share price plus the dividend yield. The percentage change in the share price is

Tim Koller, Marc Goedhart and David Wessels (2015) Valuation: Measuring and Managing the Value of Companies, Chapter 4 ‘The Alchemy of Stock Market Performance’.



137.5

125−1

⎛⎝⎜

⎞⎠⎟×100 = 10%

The dividend yield is the dividend distributed in a period divided by the equity value at the start of the period, so

5.5

125×100 = 4.4%

And TRS is 14.4%.

Now consider the traditional decomposition of TRS. The percentage change in earnings is

107

100−1

⎛⎝⎜

⎞⎠⎟×100 = 7.0%

The change in P/E is

10.3

10−1

⎛⎝⎜

⎞⎠⎟×100 = 3.0%

The dividend yield is the same, 4.4%. And TRS is 14.4% (matching the

figure obtained above).

Now consider the enhanced decomposition of TRS. The percentage growth

in earnings is the same, 7%. The required investment (in terms of return to shareholders) is the increase in capital expressed as a percentage of the

equity value in the base year, so

107 −100

125×100 = 5.6%

The TRS from performance is then the earnings growth less the required investment, so 1.4%.

The next element in the enhanced decomposition is the zero growth return. Koller et al note on pages 56–57 of your textbook that this can be calculat-

ed as the inverse of the P/E, which in this case equals

1

10×100 = 10%

The change in P/E is the same at 3%. As a check, adding together the elements of the enhanced decomposition gives TRS equal to 14%, as

shown in Exhibit 4.4

1.4% +10% + 3% = 14%

Now that you have read this section on the TRS decomposition, you can see it is difficult to raise the TRS further if it is already at a high level. This

is likely to be the case for any well-run company, and a subsequent decline in the share price relative to the overall market would be expected over the



long run. The current share price is therefore an informative source of expectations performance that has already been built in.

The traditional TRS decomposition is not an appropriate analysis in and of itself, if one takes the expectations treadmill into account. Further, the expecta-

tions treadmill disconnects executive compensation from the true drivers of value creation, namely revenue growth, ROIC, and the performance TRS (the

first two parts of TRS decomposition). For instance, instead of using stock options as management compensation, you can see that compensation should

be awarded in relation to the performance elements in the decomposition of TRS (i.e. relative to the industry). Essentially, the short-run movement of share

prices is of little value when it comes to performance evaluation.

Study Quest ion

Based on the following financial information:

$ Mil l ion Base year One year later Invested capital 200 208 Earnings 20 22 P/E 12 12.6 Equity value 240 277.2 Dividends 10 12.

the traditional breakdown of TRS is

TRS =D

1

P0

+E

1

E0

−1⎛⎝⎜

⎞⎠⎟+

P1

E1

P0

E0

−1⎛⎝⎜

⎞⎠⎟

= 12

240+ 22

20−1

⎛⎝⎜

⎞⎠⎟+ 12.6

12−1

⎛⎝⎜

⎞⎠⎟

= 0.05+ 0.10+ 0.05

= 0.20

= 20%

Obtain the enhanced breakdown of TRS:

What is the TRS from performance?

What is the zero-growth return?

What is the change in the price/earnings ratio?

Try to work out the answers on your own, before reading on.

The percentage change in earnings is

E1

E0

−1⎛⎝⎜

⎞⎠⎟= 22

20−1

⎛⎝⎜

⎞⎠⎟= 0.10 = 10%

The required investment (in terms of return to shareholders) is the increase

in capital expressed as a percentage of the equity value in the base year:



208− 200

240= 0.033= 3.3%

The TRS from performance is the earnings growth less the required invest-ment, so 10 – 3.3 = 6.7%.

The zero-growth return is the inverse of P/E, so

1

12= 0.083= 8.3%

The change in the price/earnings ratio is

P1

E1

P0

E0

−1= 12.6

12−1= 0.05= 5%

And to check, TRS = 6.7 + 8.3 + 5.0 = 20%

Please note that the TRS without breakdown, equal to the change in share price plus the dividend yield, is slightly different at 20.5%, and should be

ignored for this question1:

TRS =D

1

P0

+P

1

P0

−1⎛⎝⎜

⎞⎠⎟

= 12

240+ 277.2

240−1

⎛⎝⎜

⎞⎠⎟

= 0.05+ 0.155

= 0.205

= 20.5%

1.9 Conclusion This unit has provided an introduction to the fundamental principles of valuation using the method of discounted cash flow. You have seen why it is

important to obtain reliable and accurate estimates of company value. You have also studied the key drivers of value creation, and the principle of value

conservation. Anything that increases cash flow adds value to the company – anything that does not affect cash flow will not affect company value.

In your analysis of the maths of value creation you have examined the key value driver formula, in which net operating profit from operations less

adjusted taxes (NOPLAT), growth, the return on invested capital, and the cost of capital drive value creation. This formula is useful for understanding

the fundamental principles of valuation. The key value driver formula can be used to value companies, but only if it is realistic to assume the growth rate,

ROIC and WACC are constant. In practical applications we are more likely to forecast annual cash flow over an explicit forecast period, and to use the

1 This is also discussed in Koller, Tim, Marc Goedhart and David Wessels (2015) p54.



key value driver formula to value cash flow beyond this explicit forecast period, either because it is safe to assume the company has reached a steady

state by then, or because it is not informative to make forecasts for individual years so far into the future.

Your study of the conservation of value, risk and value, and the enhanced decomposition of TRS have reinforced the idea that we should focus on the

factors affecting the company’s true long-term performance, and you should be aware of the dangers of being distracted from this by, for example, short-

term movements in share prices, or changes in accounting or reporting that do not affect value.

The fundamental concepts you have studied in this unit are very powerful, but they have been presented in stylised and simplified examples. To perform

valuation analysis, and to assess the accuracy of value estimates, we need to examine in more detail the elements of the valuation process. You will do

this in Units 2 to 6.

Unit 2 discusses the return on invested capital and revenue growth, and the

difficulties involved in sustaining ROIC and growth. Unit 3 introduces the detail of the discounted cash flow model, and compares it to alternative

methods. It also presents the reorganisation of accounting statements to derive measures of cash flow. Unit 4 is concerned with the analysis of

performance, and how to forecast future cash flows. Unit 5 discusses the methods available to estimate the cost of capital, and the adjustments needed

to move from the value of operations to value per share. Unit 6 is concerned with reporting results, including sensitivity analysis, valuation in alternative

scenarios, and comparison with peer companies operating in the same market or sector.



References Dobbs, Richard and Werner Rehm (2005) ‘The value of share buybacks’, McKinsey Quarterly, August, http://www.mckinsey.com/insights/corporate_finance/the_value_of_share_buybacks

Grullon, Gustavo and Roni Michaely (2002) ‘Dividends, share repurchases, and the substitution hypothesis’, Journal of Finance, 57, pp. 1649–84.

Hull, John C (2014) Fundamentals of Futures and Options Markets, Eighth edition, Boston: Pearson.

Koller, Tim, Marc Goedhart and David Wessels (2015) Valuation: Measuring and Managing the Value of Companies, Sixth edition, Hoboken New Jersey: John Wiley & Sons, Inc.

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