VALUATION Measuring and Managing the Value of ~ Companies TOM COPELAND TIM KOLLER JACK MURRIN McKinsey & Company, Inc.Framework for Valuation “Jo use discounted cash flow (DCF) analysis for decisions like ~ acquisitions, divestitures, or for developing, corporate strategies, _ you need a framework that answers practical questions like: * How is cash flow defined? ‘| + What is an appropriate discount rate? + For how long a time period should you forecast cash flow? ‘This chapter begins to answer these and other practical valua- “tion questions, and presents a framework for valuing businesses and strategies. It is followed by chapters that describe a step-by- step approach to using the framework. ‘THE RECOMMENDED DCF FRAMEWORK While a number of alternative DCF frameworks are conceivable, _We recommend an approach we will refer to as the “components model.” This approach asserts that the value of a company’s equity is equal to the sum of the present value of the various cash 7FRAMEWORK FOR VALUATIOg flow streams that ultimately add up to the cash flow to the equig holders (dividends, share repurchases, and share issues). Exhibit 4.1 illustrates this approach for a single-business company Rather than value the equity directly as the present value of the dividends and other cash flow to shareholders, the equity ig Exhibit 4.1 SIMPLE COMPONENT VALUATION OF A |i SINGLE-BUSINESS COMPANY | Operating 0 100 free cash flow 40 ie 10 oo 10 —— Cash low | to debtholders ig m Debt i | value 3 a | 20 = Cash ttow to equity owners 5 ot Operating value Equity value «o MFRAMEWORK FOR VALUATION. ly add up to the cash flow to the equity | yalued.as the present value of the operating free cash flow less repurchases, and share issues). Exhigy | yyesent Value of the cash paid to and received from the com- yach for a single-business compan fay’s debtholders. As long as the discount rates are selected ity directly as the present value of th openly to reflect the riskiness of each cash flow stream, the » flow to shareholders, the equity | __ Efmponents approach will result in exactly the same equity value xt the direct discounting of cash flow to the shareholders This approach is especially useful when extended to a multi- pusiness company, as shown in Exhibit 4.2. The equity value of RI VALUANON ORD 2 pany equals the sum of the values of the individual ENT VALUATION OF A, : the cor A — ,peilint, wits plus cash-yenerating corporate assets, less the © Operating o 1 oper of operating the corporate center and the value of the com- Weeahtow 55 140 Simi? COMPONENT VALUATION OF A «o 0 AULTIBUSINESS COMPANY 1,750 Excess marketable 190) securities Corporate ia Market value: Of debt = Cash tow Unit Of preferred fo debtholders a 8 stack 69 ee) Unit8 Unita ® Cash flow tw equity owners He wo 8 Oe Toaivaie Toll omnes fu” cmety ny a ‘ai oneal overhead100 FRAMEWORK FOR VALUATION, pany’s debt. ‘The exhibit helps to highlig recommending this approach. t the reason * Valuing the components of the business, instea equity, helps in identifying of just the and understanding the s investment and financing sources of value for the ec ho ate qtity This approach helps to pinpoint key leverage areas in the ch for value-creating ideas. * Itcan bea tiol ied consistently at ferent levels of aggreg and is consistent with the capital budgeting process most companies are already familiar with + It is sop ticated enough to deal with the complexity of most situations, while at the same lime it is easy to imple- ment with simple personal computer tools Let us now apply the model to a simple single- pany. (Later we will discuss more complex situations.) The value of the company’s equity equals the present value of its operations less the value of its debt (our example company has no other nonequity obligations like preferred stock). The value of op erations and debt is equal to their respective cash flows dis counted at a rate that reflects the riskiness of these cash flows. Exhibit 4.3 is a simple valuation s y for the Hershey Foods uusiness com- Corporati Value of Operations The value of operations equals the discounted value of expected future free cash Free cash flow is equal to the afte operating eamings of the company plus noncash charges less investments in working capital, property, plant and equipm and other assets. It does not incorporate any financing-related cash flows such as interest expense or dividends. Exhibit 4.4 shows a summarized free cash flow calculation for the Foods Corporation. Free cash flow is the correct cash flow for this valuation model because it reflects the cash flow generated by a company that is available to all providers of the company's capi Jersheysit helps to highlight the reasons jg, roach. 5 nents of the business, instead of just the | nntifying and understanding the separaty, rancing sources of value for the equity 2 to pinpoint key leverage areas in the eating ide | onsistently at different levels of aggrega. tent with the capital budgeting process re already familiar with. enough to deal with the complexity of hile at the same time it is easy to imple. personal computer tools. 2 model to a simple single-business com. “uss more complex situations.) The value equals the present value of its operations bt (our example company has no other ike preferred stock). The value of op. jual to their respective cash flows dis- eflects the riskiness of these cash flows. sluation summary for the Hershey Foods equals the discounted value of expected Free cash flow is equal to the after-tax he company plus noncash charges less capital, property, plant and equipment, 2 not incorporate any financing-related erest expense or dividends. Exhibit 4.4 ee cash flow calculation for the Hershey cash flow is the correct cash flow for this e it reflects the cash flow generated by a | le to all providers of the company’s capi- | | | 101 ge CONMENDID DCF FRAMEWORK =p.) HERSHEY FOODS CORPORATION, VALUATION Baht UMMARY, 5 MILLIONS Feoe cash Discount fac- Present Year flow (CH tor @ 11.5% — valueof FCF 1987 35 0.8969) 7 1968 0 0.b044 80 909 121 0.7214 87 1990 133 0.6470 86 1991 146 0.5803 85 1992 161 0.5204 as 1993 Wr 0.4667 83 1994 195 0.4186 8 1995 214 0.3754 80 996 235, 0.3367 79 Continuing value 4,583 0.3367 1,843, Yalue of operations 2,374 Less: Value of debt 254) Equity value Equity value per shave AAS tal, both debt and equity. In fact, free cash flow is also equal to the sum of the cash flows paid to or received from all the capital providers (interest, dividends, new borrowings, debt repay- ments, and 80 on) For consistency with the cash flow definition, the discount rate applied to the free cash flow should reflect the opportunity cost to alll the capital providers weighted by their relative con- tribution to the total capital of the company. This is called the weighted average cost of capital (WACC). The opportunity cost to any investor equals the rate of return the investor could expect to cam on other investments of equivalent risk. The cost to the company equals the investors’ costs less any tax benefits received by the company (for example, the tax shield provided by inter- est expense). Exhibit 4.5 shows a sample WACC calculation for Hershey Foods102 FRAMEWORK FOR VALUATION Exhibit 44 HERSHEY FOODS CORPORATION, FREE CASH FLOW CALCULATION, § MILLIONS Earnings before interest_and taxes (EBT) 1 soe a4 Cash taxes on €BIT 35) 16) at Neto Depreciation 50 56 63 0 Change in wo Capital expenditures 105 7 a in net other asset Operating free cash flow Financing flow Net interest expense after 8 7 16 2» Decreaserinceease) in net 198) 4 1 1 debt ‘ommon dividen “4 48 6 65 3 share repurchases 8 An additional problem in valuing a business is its & One approach is to forecast the free cash flow for one hundred yeai 3 and not worry about what comes after, because its discounted value 7 will be tiny. Alternatively, you can make the problem tractable by 6 separating the value of the business into two lime periods, during al and after an explicit forecast period. In this case Present value of cash flow after explicit forecast period value of cas plicit forecast periodFRAMEWORK FOR VALUATION. | _ yp gECOMMENDED DCF FRAMEWORK 103 | Oe CCC‘“‘(ae_CCid CORPORATION, FREE CASH FLOW | 3 HERSHEY FOODS CORPORATION, WACC CALCULATION [ENE CTEECT ty — Propor Contrib fore fore For won Oppor tion i cot ca cat clioal —tunly Tax Atertax weighted le a ee ais ie F souce of Can aia ot ave 1996 -2a70 ae? aes eae peor riaee 9962.7 : a son ae «ON OOK TS ins) en) any aan gary | BR ot on rT a a7 jighted averane . a7 304 334460, wet capital (og ive) att lay BREE us 19 Tae 2a 2a | 2 - 70. Pr A . : The value after the explicit forecast period is referred to as the ‘continuing value. Simple formulas can be used to estimate the continuing value without the need to forecast the company’s cash 126 79 flow in detail for an indefinite period. For example, one approach 7 estimates the continuing value using the following formula: 8 7 6 BS Continuing vaine = NeLeperating profit es ad a . pear tee aman jeighted average cost of capital 486 Value of Debt . Ihe value of the company’s debt equals the present value of the cash flow to the debtholders discounted at a rate that reflects the skiness of that flow. The discount rate should equal the current market rate on similar-risk debt with comparable terms. In most | ' cases, only the company’s debt outstanding on the valuation date eee business is its indefinite life. | must be valued. Future borrowings can be assumed to have zero the free cash flow for one hundred years} __net present value because the cash inflows from these borrowings comes after, because its discounted value will exactly equal the present value of the future repayments you can make the problem tractable by discounted at the opportunity cost of the debt. i “business into two time periods, during ist period. In this case, : Value of Equity Present value of cash flow ‘The vaiue of the company’s equity is simply the value of its after explicit forecast period operations less the value of its debt. cash flow ast period104 FRAMEWORK FOR VALUATION, OTHER DISCOUNTED CASH FLOW FRAMEWORKS S. However, each hee Other discounted the component approach we recomm drawbacks, and their usefulness for pr ited. Direct Discounting of Equity Cash Flow directly discounting the cash flayy Valuing a company’s equity b' to the equity holders (dividends and share repusche itively the most straightforward valuation technique. Un fortunately, it is not as useful or easy to implement as the ‘ing equity cash flow provide value creation and is not ag ponents approach. Discou information about the sources useful for identifying value-creation opportunities. Furthermore ful adjustments to ensure that changes in ny’s value. in discounted equity it requires ¢ financing do not incorrectly affect the comp For example, a common error that we see valuations is an inconsistency between the company’s d policy and ‘ount rate used. First, a base valuation is per- Formed that results in a value of, say, $15 per share. Next, the dividend payout ratio is increased but the operating performance ange in revenues or remains constant (for example, there is no 1 The equity value has just increased because of ant operating margins). Pres the higher dividend payments despite the con: performance. The enor here is that the discount rate was no eranged. Increasing the dividend payout ratio requires more us Of debt. More debt means tiskier equity and a higher discount r2 for the equity Using Real Instead of Nominal Cash Flow and Discount Rate uation approach is to forecast cash flow in real ter Another v in constant 1988 dollars) and discount this cash fle (for example, data real discount rate (for example, the nominal rate less expected k in terms of nominal inflation). However, most managers # rather than real measures, so nominal measures are often easic to communicate. Interest rates are generally quoted nominall an in real terms (excluding expected inflation). More piscot The 8 after flow trates as ace mi is pF raISCOUNTED CASH FLOW FRAMEWORKS 105 FRAMEWORK FOR VALUATION ek DI ol SH FLOW FRAMEWORKS sg, we have found tha since historia financial statemens6 2 7 megliy nominal terms, forecasting future statements in real 3! rameworks yield the same results ag) gers i dificult and confusing, commend. However, each hag for practical applications is lim. | pjscounting pretax Cash Flow Instead of After-tax Cash Flow ste approach we recommend uses after-tas cash flow and an _Montax discount rate. It 15 conceptually valid to use pretax cash ae and a pretax discount rate, a8 the following example illus- trates. ‘Cash Flow by directly discounting the cash flow dends and share repurchases) is in. | forward valuation technique. Un. ful or easy to implement as the com. ating equity cash flow provides less rces of value creation and is not ag xreation opportunities. Furthermore, nts to ensure that changes in projected y affect the company’s value ‘error that we see in discounted equity ‘After-tax cash flow Ae ‘After-tax discount rate = Pretax cash flow % (1 - tax rate) ‘After-tax cash flow = Pretax discount rate * (1 ~ tax rate) ‘After-tax discount rate substituting into the initial equation gives Pretax cash flow (I= tax rate) _ ney between the company’s dividend | Value = =—— ‘used. Fi i stax discount rate (1 ~ fax rat te used. First, a base valuation is per- Pretax discount rate * ( ) alue of, say, $15 per share. Next, the | eich ae Value = Pretax sash Tow. creased but the operating performance Pretax discount 1a iple, there is mo change in revenues or ity value has just increased because of | nents despite the constant operating However, real-world after-tax cash flow is not simply pretax nen ee discount rate wes nol Baty a flow adjusted by the t2x rate, Because tases. ave bared on cod yout ratio requires more use aon fa accounting, (for example, the tax benefit of purchasig & 7 . ‘uate Fahne is received in a different period from when the machine riskier equity and a higher discount rate ig paid for). As a result, no practical way exists to calculate a pretax discount rate, You cannot simply gross uP the discount | Tate to a pretax rate and discount pretax cash flow. Itis virtually iscount Rate | {mnpossible to perform a valid real-world discounted cash flow analysis using the pretax approach. ninal Cash Flow and ich is to forecast cash flow in real terms ‘O88 dollars) and discount this cash 0 | formyacbased DCF Approaches Instead of Explici example, the nominal rate less expected Foren arash Flow t managers think in terms of nominal | t enoninal measures are often easier Formula-based DCF approaches make simplifying assumptions rates are generally quoted nominally | ss and its cash flow stream (for example, een 5 (excluding expected inflation). More: intire discounted cash - about a busine: “revenue growth and margins) 0 that the &106 FRAMEWORK FOR VALUATION flow can be captured in a concise formula. Unfortunately, th formulas are most often too siz al problem solving though they may serve as valuable communication tools. The Miller-Modigliani (MM) formula, while simple, is particu, larly useful for demonstrating the sources of a company’s value, The MM formula shown in Exhibit 4.6 values a company as the im of the value of the cash flow of its assets currently in pI plus the value of its growth opportunities. The formula is based On sound economic analysis, so it can be used to illustrate the key factors that will affect the value of the company Option-Pricing Models Option-pricing models are variations on standard discounted cash flow models that adjust for the fact that management de. ILLER-MODIGLIANI DCF FORMULA entity = Value of assets in place + Value of growd (NOPLAT} Value of assets in place and is determined b «+ level of expected cash flows after taxes, E(INOPLAT), where NOPLAT ands for net operating profit less adjusted taxe + weighted average cost of capital (WACC) after tax |_wace WACGIT + WACC) Value of growth = KIE(NOPLATIIN «+ fate of return on invested capital 4H] in excess of WACC + investment rate (K}—that is, the percentage of cash flows invested ir interval of ive advantage (N)concise formula, Unfortunately, these 100 simple for real problem solving valuable communication tools, MM) formula, while simple, is particy. ing the sources of a company’s value n Exhibit 4.6 values a company as the sh flow of its assets currently in place h opportunities. The formula is baseq s, So it can be used to illustrate the key value of the company. . > variations on standard discounted ust for the fact that management de. GLIANI DCF FORMULA ENTERS of assets in place + Value of growth E(NOPLAT) sin place Wace Wws after taxes, E(NOPLAT), where NOPLAT profit less adjusted taxes f capital (WACC) after tax reWACC NOPLATIN WACCH + WACG d capital (fin excess of WACC is, the percentage of cash flows invested in dvantage (N} be use’ gue DISCOUNTED CASH FLOW FRAMEWORKS 107 o fons can be modified in the future as more information be- Sr available. Option models hold particular promise for valu- ome atepic and operating flexibility such as opening and closing ABs, abandoning operations, or natural resource exploration Plat jevelopment. Chapter 12 discusses how option pricing might ane Sed as the technology is further developed SUMMARY ‘this chapter has introduced the DCF valuation framework. The value of the company’s equity equals the value of its operations jess the value of its debt. The value of operations is the dis- counted value of its expected free cash flow, using an opportunity ‘cost of capital. ‘The following chapters describe a step-by-step approach to "valuing a company, as summarized in Exhibit 4.7. They explain both the technical details, such as how to calculate free cash flow fyom complex accounting statements, and how to interpret the ~ yaluation through careful financial analysis.FRAMEWORK FOR VALUATION \L4.7 STEPS IN A VALUATION Forecasting free cash flow (Chapter 5) ‘cently componenis offre cask ow Develop integrated historical perspective mie forecast assumptions and saenerios Calculate and evaluate the forecast Estimating the cost of capital (Chapter 6) ‘© Davolop targot markt value weights Estimate cost of nonequiy tance Estimate cost of equity Estimating continuing vatue (Chapter 7) DDotermine tho relationship between continuing value and DOF Doni forecast horizon ‘© Estimate the parameters Discount tothe present Calculating end interpreting results (Copter