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VALUATION

The guiding principle of value creation is that companies create value by


investing capital they raise from investors to generate future cash flows at rates of
return exceeding the cost of capital.
The faster companies can increase their revenues and deploy more capital at
attractive rates of return, the more value they create. The combination of growth
and return on invested capital (ROIC) relative to its cost is what drives value.
Conservation of value: Anything that does not increase cash flows doesnt
increase value. (Assume: No changes in companys risk profile)
Concept of Increasing Returns.
In the past 30 years, the world has seen 6 financial crises that arose simply
because companies were financing illiquid assets with short-term debt.
Economic crises typically stem from excesses in credit rather than equity markets.
Investors value long-term cash flow, growth and return on invested capital.
When analyzing a prospective acquisition, the question most frequently posed is
whether the transaction will dilute EPS over the first year or two.

Fundamental Principles of Value Creation
Return on Invested Capital: After-tax operating profit divided by invested capital
(Working Capital + Fixed Assets)
Amount of value a company generates is governed ultimately by its ROIC,
Revenue Growth and its ability to sustain both over time.
Total Shareholders Returns = Dividends + Appreciation in Share Price
Value = Sum of the present values of future expected cash flows a point in time
measure
Value Creation = Change in Value due to company performance
Sometimes use market price of a companys shares as a proxy for value.
Sometimes use total returns to shareholders as a proxy for value creation
Revenue Growth + ROIC + Cash Flow: are tightly linked
( )


Value increases with increase in ROIC. The same cannot be said for growth. In
fact, for a low ROIC, growth decreases value. Low ROIC and high growth is only
true for young, start up businesses.
If ROIC = Cost of Capital, then growth rate doesnt make a difference.
For the most part, Asian companies historically have focused more on growth
than profitability or ROIC, which explains the large difference between their
average valuation and that of US companies.
Companies earning a high ROIC can generate more additional value by increasing
their rate of growth, rather than their ROIC, while low ROIC companies will
generate relatively more value by focusing on increasing their ROIC.
The previous discussion assumed that all growth earns the same ROIC and thus
generates the same value. This is unrealistic.
See pecking order of growth-related value creation that applies to its industry and
company type.
Some high value creators were those who grew fast at the expense of moderate
decline of ROIC. They were much higher value creator than those who increased
their ROIC but grew very slowly.
The cost of capital to a company equals the minimum return that investors expect
to earn from investing in the company. Thus, the expected return to investors and
cost of capital are essentially the same.
Shouldnt take risk on a project that has heavy spill over effect on the main
company.