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Session 5 & 6
In VBM companies, shareholder value creation is the only objective
± Value creation is typically measures using an economic profit or residual income metric (such as EVA), given the amount of total capital used to generate that profit ± These metrics and their value drivers are solely used to evaluate business performance ± Target setting (at all levels of organisation) are based on measures that can be affected by employees, and focus is on value drivers that simulate value creation ± Bonuses are based upon changes in metric (EVA)
What VBMS does not do
± VBM does not solve the problem of using different financial measures ± In practice, it is adopted differently at different org levels, and measured in various ways ± It does not lead to decentralisation or empowerment of business units
Models to Measure Value Creation
Marakon Model Alcar Model Mckinsey Model
The model highlights three primary financial drivers of value
± Returns/profitability: The company s profitability as measured by its RoE and its RoI ± Growth: The growth rate of the company s capital, which reflects growth in revenue, and for a given RoE and RoI, drives earnings growth
g = reinvestment rate x RoE
± Risk: The company cost of capital its cost of equity and its WACC
CoE and growth rate of capital ± The price/book ratio is the ratio of the market value of equity to the book value of equity ± PB ratio = MV of Equity / BV of Equity Going back of a simple DDM ± ± ± ± P0 = D1/(r g) = EPS0 x payout ratio x (1 + g) / (r-g) P0 /BV0 = (EPS0/BV0) x payout ratio x (1+g) / (r-g) PB0 = RoE x payout ratio x (1+g) / (r g) current RoE PB = RoE x payout ratio / (r g) Forward RoE Conclusions ± A firm s MV is higher than its BV only if RoE is greater than CoE (r) ± When RoE > CoE. the higher the value of growth rate (g).Marakon Model The model measures a firm s market value to book value ratio. the higher is its MV to BV ratio . and links it to RoE.
Marakon Model Calculate MV/BV for the firm with: ± RoE = 20% ± g = 8% ± CoE = 10% What happens to this ratio if RoE declines to 15% and g to 5% in the next two years? ± What does this means about earnings quality .
Marakon Model The last example highlights that there is a fourth strategic driver of value. which is sustainability (of profitability. growth. risk control) Sustainability depends upon: ± Economic attractiveness of the market in which the company operates this determines market s average equity spread (RoE CoE) and growth over time ± Competitive advantage of the company in the market This determines company s relative equity spread and relative growth over time .
Marakon Model Summary: A firm can maximise its shareholder value by focusing on both earnings quantity and quality by: ± Understanding financial drivers: investing capital as much capital as possible at rates of return that exceed the cost of capital ± Understanding strategic drivers: Investing capital to improve company s strategic position by entering more attractive markets and building competitive advantages ± Formulating strategies focus on the above two ± Aligning management s interest with firm s interest .
Alcar (SVA) Model Developed by Rappaport in 1986 Alcar model uses DCF to identify value creating strategies Value of the strategy is the difference between the post-strategy market value and the pre-strategy market value of firms strategy Alcar approach has seven value drivers ± ± ± ± ± ± ± Annual growth rate of sales Operating profit Margin Income tax rate Incremental Working capital Incremental investment in fixed assets Value growth duration Cost of capital .
Alcar Model Value of Operations = PV of FCF during value growth duration + PV of FCF after value growth duration (residual value or terminal value) Business Valuation = Value of operations + value of marketable securities & investments Value of debt For terminal value. it is assumed that the firm is in steady state and its RoC = CoC FCF Calculation .
Sales grew 143% y-o-y to Rs36. and are expected to grow 134% in FY11.Alcar Model Infogain is in the business of providing software development and data management primarily for BFSI segment.4mn in FY10. desktop applications. . high growth in sales and profits is projected over the next 5-10 years. content. and web management. The company was established in 2007 and spent the first three years in developing its product portfolio. comprising of web products. The company has just come off development stage and is leveraging its broad suite of products to rapidly grow its sales. Considering the company is in an expansion phase of its life cycle.
growth is projected to be 8% and reinvestment rate of 10% of EBITDA.5% (beta of 2. Cost of Equity is assumed to be 24. In the constant growth phase assumed for terminal value calculation. EBITDA margin to improve from 2% in FY10 to 22% in FY11 to 45% in FY15. The improvement will be driven by rationalization of employee and administrative costs in the backdrop of rising product sales ± 3.0) during FY11FY12 and then decline to 18% (beta of 1. Capex over the forecast period will remain in the range of 7%-9% of sales or 15%-25% of EBITDA to support sales growth ± 4. Determine the value of the company based on Alcar model ± Test sensitivity of equity value based on Alcar value drivers . ± 5. For the calculation of Terminal valuation. Sales CAGR of 45% over the period FY10-FY15 ± 2. cost of equity (and capital) is assumed to be 15%.4) by FY15 to reflect the growing acceptance of the company s products. Key Assumptions in Model are: ± 1. Cost of debt will be 9% in the forecast period.
Alcar Model SVA can be used for business valuation as well as evaluating alternative business strategies Sensitivity analysis is possible as the model has a simplified approach with only seven value drivers ± The seven key drivers can be broken down into more detailed & practical performance measures and targets Disadvantage lies in predicting variables required in the analysis .
According to it.Mckinsey Model Mckinsey is a comprehensive approach to value-based management. key steps in maximising value of a firm are: ± ± ± ± ± ± ± Management s goal is shareholder value maximization Identification of the value drivers Development of strategy Setting of targets Deciding upon action plans Setting up the performance measurement system Implementation .
Mckinsey Model Key features Use of published accounting data as input ± Historical ratios are used as a starting point for making predictions for the same ratios in future Values equity of a going concern ± Asset side is valued first. turnaround. major product/service launches FCF is calculated from forecasted income statements and balance sheet . such as take-over. at least 7 10 years. forecast period should be long-enough to capture transitory effects. Value of interest-bearing liabilities is then subtracted to get value of equity Current liabilities are part of operations. not financing Deferred income taxes are viewed as part of equity ± Value of asset side = value of operations + excess marketable securities ± Operations of the firm is valued by discounting FCF from operations using WACC FCF is forecasted for explicit forecast period.
g. Gordon growth) FCF in post-forecast period increases by some constant percentage every year Mckinsey model is comprehensive so as to model all possible value drivers .Mckinsey Model Key features Terminal or continuing value is calculated from an infinite discounting formula (e.
based upon its characteristics in terms of cash flows.DCF Approach In discounted cash flow valuation. the value of an asset is the present value of the expected cash flows on the asset Philosophical Basis: Every asset has an intrinsic value that can be estimated. growth and risk Information Needed: To use discounted cash flow valuation. you need ± to estimate the life of the asset ± to estimate the cash flows during the life of the asset ± to estimate the discount rate to apply to these cash flows to get present value .
to capture the value at the end of the period: . we estimate cash flows for a growth period and then estimate a terminal value.DCF Valuation A publicly traded firm potentially has an infinite life. The value is therefore the PV of future cash flows Since we cannot estimate cash flows forever.
DCF Choices: Equity valuation vs. Firm valuation Firm Valuation: Value the entire firm Equity valuation: Value just the equity claim in the business .
Equity Valuation .
Firm Valuation .
Measuring Cash Flow .
In cases where leverage (DR or Debt to capital ratio) of the company is stable. Estimate FCFE ± ± ± ± ± Net income: Rs125 cr Capital spending: Rs150cr Depreciation: Rs50 cr Increase in non-cash working capital: Rs 50 cr New debt proceeds: Rs 75 cr. FCFE is calculated as ± Net income (1-DR) x (Capex Depr) (1-DR) x Chg in WC Capital = FCFE ± For such a firm. Estimate FCFE ± ± ± ± ± Net income: Rs125 cr Capital spending: Rs150cr Depreciation: Rs50 cr Increase in non-cash working capital: Rs 50 cr Debt to capital ratio: 25% . proceeds from new debt issues = Principal repayments + DR x (capex Depr + Working Capital) 3. No change in old debt 2. Tax rate for the company is 30%.Calculating FCFE/FCFF 1. Estimate FCFF for the above firm if total debt outstanding was Rs500cr and average interest rate on debt was 10%.
To the extent that depreciation provides a cash flow.e.Estimating Cash Flows Estimate the current earnings of the firm ± If looking at cash flows to equity. ± Increasing working capital needs are also investments for future growth If looking at cash flows to equity. it will cover some of these expenditures. look at operating earnings after taxes Consider how much the firm invested to create future growth ± If the investment is not expensed.i. look at earnings after interest expenses . net income ± If looking at cash flows to the firm.debt repaid) . it will be categorized as capital expenditures. consider the cash flows from net debt issues (debt issued .
Generic DCF Valuation Model .
depending upon whether the cash flows are nominal or real ± Discount rate can vary across time. Estimate the current earnings and cash flows on the asset. Choose the right DCF model for the asset and value it .DCF Valuation Estimate the discount rate or rates to use in the valuation ± Discount rate can be either a cost of equity (if doing equity valuation) or a cost of capital (if valuing the firm) ± Discount rate can be in nominal terms or real terms. to either equity investors (CF to Equity) or to all claimholders (CF to Firm) ± Estimate the future earnings and cash flows on the firm being valued ± Estimate when the firm will reach stable growth and what characteristics (risk & cash flow) it will have when it does.
Firm ± Cost of Equity: Higher for riskier investments and lower for safer investments Only systematic risk is rewarded as investors are well-diversified CAPM: Cost of Equity = Riskfree rate + Equity beta x Equity Risk Premium ± In practice: Govt security rates are used as risk-free rates ± Historical risk premiums are used as risk premium ± Beta is estimated by regressing stock returns against market returns ± Cost of Capital: Weighted average of Cost of Equity and Cost of Debt Cost of debt is the interest rate at which the company can borrow currently Weights are market values of debt and equity .Discount Rates Discount rate should be consistent with both the riskiness and the type of cashflow being discounted ± Equity vs.
patents) Use a 2-Stage Growth Model If firm ± is small and growing at a very high rate (> Overall growth rate + 10%) or ± has significant barriers to entry into the business ± has firm characteristics that are very different from the norm Use a 3-Stage or n-stage Model .g.Which Growth Pattern to Use If firm is ± large and growing at a rate close to or less than growth rate of the economy. or ± constrained by regulation from growing at rate faster than the economy ± has the characteristics of a stable firm (average risk & reinvestment rates) Use a Stable Growth Model If firm ± is large & growing at a moderate rate ( Overall growth rate + 10%) or ± has a single product & barriers to entry with a finite life (e.
DCF Models Free Cash Flow to Equity model Free Cash Flow to Firm Model .
(Principal Repayments .Depreciation) Changes in non-cash Working Capital . Actual dividends.FCFE In the strictest sense.new debt issues) i. using a model that focuses only on dividends will under state the true value of the equity in a firm The potential dividends of a firm are the cash flows left over after the firm has made any investments it needs to make to create future growth and net debt repayments (debt repayments . Free Cash Flow to Equity ± Free Cash flow to Equity = Net Income . are set by the managers of the firm and may be much lower than the potential dividends (that could have been paid out) When actual dividends are less than potential dividends. the only cash flow that an investor will receive from an equity investment in a publicly traded firm is the dividend that will be paid on the stock. however.(Capital Expenditures .e.New Debt Issues) Pref Dividends .
Dividend vs FCFE Use the Dividend Discount Model ± (a) For firms which pay dividends (and repurchase stock) which are close to the Free Cash Flow to Equity (over a extended period) Use the FCFE Model ± (a) For firms which pay dividends which are significantly higher or lower than the Free Cash Flow to Equity.year period. if dividends are less than 80% of FCFE or dividends are greater than 110% of FCFE over a 5. use the FCFE model) ± (b) For firms where dividends are not available (Example: Private Companies.. IPOs) . (What is significant? .. As a rule of thumb.
Equity Valuation with FCFE .
Valuing a Firm .
0% 00 .0% 000 Fully onsolidated 0 0. % .0% .0% . You have been able to obtain both the fully consolidated and parent company financials for Mayrond Textiles.0% 0.Valuation example Mayrond is an apparel company that owns 80% of White Stores. Estimate the value of equity per share arent (Mayrond nly) EB T Tax ate o Expected rowth ate ost of capital ebt 00 million shares outstanding 0 0. with the following information (in millions).0% . a retail firm.0% .
Estimating Terminal Value .
the PV of those cash flows can be written as: ± Value = Expected Cash Flow Next Period / (r g) where. r = Discount rate (CoE or CoC) g = Expected growth rate This constant growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the firm operates .Stable Growth and Terminal Value When a firm s cash flows grow at a constant rate forever.
0% 8000 15293 3.0% 30.5% 10.2% 5.0% .DCF Valuation example Calculate the value of equity using FCFF and FCFE DCF method Cost of Equity Cost of Debt Tax Rate Total Debt Current Market Value of stock CF to firm stable growth rate CF to Equity stable growth rate Year 1 2 3 4 5 Cash Flow to Equity 1000 1200 1380 1518 1639 13.
Value Creation DCF approach Increase cash flows from existing operations ± Divestitures/liquidation ± Cost-reductions ± Reduce tax burden ± Reduce net capex ± Reduce non-cash working capital as a % of revenue Increase expected growth .
Value Creation DCF approach Lengthen the period of high growth Reduce the cost of financing .
40 .29 20% 12.17 3.96 2.EVA Case Study EVA Calculation Is EVA a good measure of financial performance for cyclical and capital intensive industries? Three options ± Diversification in unrelated industry ± Diversification in related industry ± Product mix (value-added products) ± Capacity addition? ± Productivity improvement? Operating Profit (EBIT) Other Charge Tax Rate NOPAT Invested Capital Cost of Capital Capital Charge EVA 17.57 85.7% 9.66 10.
10% + Investment in new projects Rs 100 X Return on Investment on new project.6% X Return on Investment = 15% = Growth Rate in Earnings: (165/150)-1 = 10% If RoI is not expected to change from year to year. the growth in earnings will come solely from new investments (and expected RoI on it) . Rs165 Reinvestment Rate: 100 / 150 = 66.Fundamentals of Growth Investment in existing projects Rs 1000 X Current Return on Investment on project. 15% = Next Period s Earnings. 15% = Current Earnings. Rs150 Investment in existing projects Rs 1000 X Current Return on Investment on project.
Fundamentals of Growth If return on existing assets increases (from 15% to 16%). gEPS = Retention ratio * ROE . expected long-term growth in EPS can be written as ± Reinvestment rate = Retained Earnings / Current Earnings = Retention ratio Return on Investment = Return on Equity In case.33% Expected growth = Growth from new investments + Efficiency growth Using the same logic. current ROE is expected to remain unchanged.15%) + 100 * 16%) / (1000 * 15%) = 17. then expected growth rate will be ± (1000 * (16% .
Debt Ratio)/ Net Income Expected Growth in Net Income = Equity Reinvestment Rate * ROE When looking at growth in operating income. the definitions are Reinvestment Rate = (Net Capital Expenditures + Change in WC)/EBIT(1-t) Return on Investment = ROC = EBIT(1-t)/(BV of Debt + BV of Equity) gEBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC or gEBIT = Reinvestment Rate * ROC .Fundamentals of Growth A more general version of expected growth in earnings can be obtained by substituting in the equity reinvestment into real investments (net capital expenditures and working capital): Equity Reinvestment Rate = (Net Capital Expenditures + Change in Working Capital) (1 .
Fundamentals of Growth In stable growth period. well-managed firms) do better at sustaining excess returns for longer periods (McKinsey & Co) . can there be growth from effficiency gain? ± Reinvestment rate = stable growth rate / stable period Return on Capital Can Return on capital be higher than cost of capital in stable period? ± Some firms (typically large.
target setting and rewards to value creation or value drivers ± Connects decision making and action planning. both strategic and financial. key elements of VBMS are ± Aims to create shareholder value ± Identifies value drivers ± Connects performance measurement.VBMS In summary. to value creation and value drivers .
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