Corporate Finance I

Value Drivers

Ernst Maug
University of Mannheim
http://cf.bwl.uni-mannheim.de
maug@corporate-finance-mannheim.de
Tel: +49 (621) 181-1951
 Introduction

→ Value drivers: the concept

→ The shareholder value approach
→ Decomposing cash flows
→ The five value drivers:
- Margins
- Growth
- Capital expenditure
- Working capital requirements
- Value growth duration

© 2021 Ernst Maug Corporate Finance I 2

 Why do we need „value drivers“?

Strategy Value Cash flows &

Value
& Decisions Driver Discount rate

→ Managers make decisions about strategic variables

→ Stock markets discount expected future cash flows to generate values
→ „Value drivers“ represent the conceptual link

© 2021 Ernst Maug Corporate Finance I 3

 The shareholder value approach

Management Value Drivers Valuation Corporate

Decisions Components Objective

• Value growth duration

Operating • Sales growth

• Operating profit margin
• Free cash flow
from operations
Investment • Working capital investment • Creating
• Fixed capital investment shareholder
value
Financing • Debt capacity • Cost of capital
• Probability of bankruptcy • Tax shields

Parameters • Tax rate, rate of inflation • Market price for risk

• Historic sales, costs, etc. • Interest rates
• Competition • Other capital market factors

© 2021 Ernst Maug Corporate Finance I 4

 Defining value

→ We need a model that relates cash flows to value drivers.

→ The value of the firm is the present discounted value of all net cash flows
accruing to security holders.
→ Then we obtain the value of the company as:

E [FCFt (value driver )]
V =
t =1 (1 + r )t

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 The valuation algorithm - overview

→ Formulate strategy and competitive scenario:

- Market share, competitive advantage, cost cutting
→ Map into value drivers:
- Identify key parameters (margin, growth, costs)
- Structural approach: identify stable relationships
→ Determine valuation using DCF or RI
→ Consistency checks and diagnostics:
- Financial ratios (multiples)
- Industry comparisons
→ If you find problems in (4), start over with (1) and (2)

© 2021 Ernst Maug Corporate Finance I 6

 The shareholder value approach

Management Value Drivers Valuation Corporate

Decisions Components Objective

• Value growth duration

Operating • Sales growth

• Operating profit margin
• Free cash flow
from operations
Investment • Working capital investment • Creating
• Fixed capital investment Shareholder
Value
Financing • Debt capacity • Cost of capital
• Probability of bankruptcy • Tax shields

Parameters • Tax rate, rate of inflation • Market price for risk

• Historic sales, costs, etc. • Interest rates
• Competition • Other capital market factors

© 2021 Ernst Maug Corporate Finance I 7

 Formulating a model

→ Businesses take as given some data:

r = Cost of capital = 7%
St-1 = Sales of previous period = €95.65
T = Tax rate = 38%
π = Inflation rate = 2.0%

→ Notation
st, St = Sales at time t (lower case: in constant prices, upper
case: in current prices)
WCt = Working capital requirement at time t
ppet = Property, plant and equipment at time t

These definitions and the numerical examples can be found

in Value Drivers - PerpetuityModel.xlsm, tab “DCF model”.

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 Formalizing the model

→ The idea is that managers influence value drivers:

g = Sales growth rate ((st-st-1)/ st-1) = 2.5%
m = Operating profit margin ((St - COGSt)/ St) = 20.0%
f = Ratio of fixed assets to sales (ppet / st+1) = 50.0%
w = Working capital requirement (WCt /St+1) = 10.0%
d = Rate of depreciation (dept / ppet-1) = 20.0%

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 Cash is king! – analyzing free cash flows

Free Cash Flow = Cash inflow - Cash outflow

Cash inflow = Sales * Operating profit margin

Cash outflow = Incremental fixed investment

+ Incremental working capital investment
+ Taxes

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 Free cash flows to the firm

Free cash flow to equity = Free cash flow

- Net payments to debtholders

Payments to debtholders = Interest payments

+ Payments of principal
- Proceeds from new issues

→ Free cash flow to equity is larger than the free cash flow to all securities
combined if proceeds from new issues exceed the sum of interest and principal
payments by the firm!

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 Accounting numbers and free cash flows

→ Take example of a firm with expected sales of €100 million

Sales revenue € 100.00
- Cost of goods sold € 80.00
= Operating profits (EBITDA) € 20.00
- Depreciation € 9.16 The free cash flow calculations can
= EBIT € 10.84 be found in Value Drivers -
- Interest € 1.56 PerpetuityModel.xlsm tab “DCF
model”.
= Taxable Income € 9.28
- Taxes € 3.53
= Net Income € 5.75
EBIAT € 6.72
- Working capital investment € 0.45
- Capital expenditure € 11.25
→ What is the free cash flow of this firm?
- What are the free cash flows to shareholders? To debtholders?

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 Free cash flow: a definition

→ Definition:
The free cash flow of period t, FCF(t) is the net cash flow received by all security
holders of the firm combined:
Example:
FCF = EBITDA € 20.00
- Taxes (= (EBIT - Interest)*T) € 3.53
- Working Capital Investment € 0.45
- Capital Expenditure € 11.25
+ Asset Sales € 0.00
= € 4.77

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 Free cash flow and accounting numbers
Recover free cash flows from EBIT

FCF = EBIT € 10.84

- Taxes € 3.53
+ Depreciation & Amortization € 9.16
- Working Capital Investment € 0.45
- Capital Expenditure € 11.25
+ Asset Sales € 0.00
= € 4.77

Principle:
If an accounting item does not generate a cash flow, add it back!

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 Recover cash flows from net income

Since Net Income = (1 - T)*(EBIT - Interest) we have the alternative definition:

FCF = Net Income € 5.75
+ Interest € 1.56
+ Depreciation & Amortization € 9.16
- Working Capital Investment € 0.45
- Capital Expenditure € 10.25
+ Asset Sales € 0.00
= € 4.77

Note: Combined free cash flows to all security holders includes payments to debt
holders. → Add back interest!

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 Unlevered vs. levered cash flows

→ The free cash flow to an unlevered firm (100% equity financed) FCFU is
calculated by assuming that interest payments are zero.
- All free cash flows the firm could pay out if it had no debt.
- Combines free cash flows to all security holders.
→ The tax shield is defined as the reduction in taxes from interest payments, tax
shield =T*Int = 0.38 * €1.56 = €0.59.
→ Free cash flows to levered and unlevered firm are:
FCFL = FCFU € 4.18
+ Tax shield (T*Int) € 0.59
= Free cash flow to levered firm € 4.77

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 Cash flows to shareholders

→ To compute the free cash flow to equity holders adjust free cash flows for
payments from and to debt holders.
- Note: Tax shields (T*Int) accrue to equity holders!

CFE = Free cash flow (FCFL) €4.77

- Interest €1.56
+ Net debt issued €1.77
= Free cash flow to equity €4.98

= FCFU €4.18
- Interest * (1 - T) €0.97
+ Net debt issued €1.77
= Free cash flow to equity €4.98

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 Value of the firm

Value of equity = PV (CFEs)

Value of debt = PV (Net cash flows to debt holders)
Value of the firm = PV (FCFs)
= PV (CFEs + Net cash flows to debt holders)
= Value of debt + value of equity

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 The shareholder value approach

Management Value Drivers Valuation Corporate

Decisions Components Objective

• Value growth duration

Operating • Sales growth

• Operating profit margin
• Free cash Flow
from operations
Investment • Working capital investment • Creating
• Fixed capital investment Shareholder
Value
Financing • Debt capacity • Cost of capital
• Probability of bankruptcy • Tax shields

• Tax rate, rate of inflation • Market price for risk

Parameters • Historic sales, costs, etc. • Interest rates
• Competition • Other capital market factors

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 Analyze margins

→ You may want to understand profit margins in more detail:

- Decompose them into their components (COGS, R&D, etc.)
- Identify the decisions behind each component
→ Use costs/sales ratios:
- Cost of goods sold / Sales → Inputs, competition?
- SG&A / Sales → Overheads, advertising?
- R&D / Sales → Investment?
- Tax expenses / Sales → Leverage?
→ to identify how company‘s strategy affects margins

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 The shareholder value approach

Management Value Drivers Valuation Corporate

Decisions Components Objective

• Value Growth Duration

Operating • Sales Growth

• Operating Profit Margin
• Free cash Flow
from operations
Investment • Working Capital Investment • Creating
• Fixed Capital Investment Shareholder
Value
Financing • Debt capacity • Cost of capital
• Probability of bankruptcy • Tax shields

Parameters • Tax rate, rate of inflation • Market price for risk

• Historic sales, costs, etc. • Interest rates
• Competition • Other capital market factors

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 Value drivers: capital expenditure

→ Capital expenditure is:

CAPEXt = ppet – ppet-1 +dept
= f ∙(st+1 - st) + d∙ppet-1
st +1 − st
= f ∙g ∙ st + d ∙ f ∙ st Note : st +1 − st = st = gst
st
= f∙(g + d)∙st

CAPEXt / st = f * (g + d)
= 0.5 * (0.025 + 0.20)
= .1125

→ You can back out f if you know d (this is economic depreciation).

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 CAPEX and asset turnover

→ Capital expenditure is closely related to asset turnover

Sales
Asset Turnover =
Assets
St s t +1 / (1 + g ) 1 1
Fixed Asset Turnover = = = 
PPE t ppe t f (1 + g ) f
→ The critical parameter for fixed asset turnover is the fixed capital requirement f.

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 Value drivers: working capital

→ Working capital comprises:

- Accounts receivables (net of accounts payable)
- Inventories
- Non interest bearing assets
→ Assume WC is constant proportion of next period’s sales
- Example: 1/12: accounts receivable paid after one month
→ Investment in working capital must be deducted from cash flows:
WCt - WCt-1 = w * St+1 - w * St
= w * G * St
= 0.10 * 0.0455 * €100
= €0.455

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 Understand asset turnover

→ Asset turnover is directly related to the parameter w = WCt /St+1

Sales
Working capital turnover =
Current assets − current liabilities
St St +1 / (1 + G ) 1 1
= = = 
WCt WCt w (1 + G ) w

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 Liquidity ratios

→ You may want to understand working capital turnover in more detail:

- Decompose WC into its components (inventories, accounts receivables, etc.)
- Identify the decisions behind each component
→ Use liquidity ratios (there are many), e.g.:
Accounts receivable
Days ' receivables =
Sales / 365
Cost of goods sold
Accounts payable turnover =
Accounts payable

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 Inflation: the effect on receivables (1)

→ Warning! Working capital investment depends on inflation:

- An increase in inflation increases working capital investment in real terms!
→ Working capital includes accounts receivable minus accounts payable.
→ These “net receivables” must be calculated in nominal terms
- even if the valuation is done in real terms.
→ Consider the following example:
- Net receivables are w = 8% of sales
- Growth rate of sales is g = 0
- Inflation is π = 5%

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 Inflation: the effect on receivables (2)

→ Calculation in nominal terms (right; WC starts at €40.00 at the end of 2019):

2020 2021 2022 2023 2024
Sales revenue 500.00 € 525.00 € 551.25 € 578.81 € 607.75 €
net receivables 42.00 € 44.10 € 46.31 € 48.62 € 0.00 €
investment in
2.00 € 2.10 € 2.21 € 2.32 €
net receivables

→ Calculation in real terms (wrong!):

2020 2021 2022 2023 2024

Sales revenue 500.00 € 500.00 € 500.00 € 500.00 € 500.00 €
net receivables 40.00 € 40.00 € 40.00 € 40.00 €
investment in
0.00 € 0.00 € 0.00 € 0.00 €
net receivables

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 Value drivers
Median industry figures as of 2018

CAPEX Op. Margin Sales Growth Working Capital

SIC Code Industry (as % of sales) (after tax) (last 5 years) (as % of sales)
2000 food and kindred products 3.28% 2.09% 4.94% 10.27%
2800 chemicals 4.95% 3.81% 17.08% 22.84%
3000 rubber and misc. plastics products 4.42% 3.00% 9.98% 16.65%
3200 stone, clay, and glass products 5.11% 3.60% 9.74% 19.91%
3300 primary metal ind. 3.15% 2.10% 14.39% 15.00%
3400 fabricated metal products 4.72% 2.73% 13.32% 19.87%
3500 industrial machinery and equipment 3.97% 3.96% 21.35% 26.23%
3600 electronic & other electric equipment 4.30% 3.68% 20.86% 26.65%
3700 transportation equipment 4.20% 2.11% 25.18% 18.23%
3800 instruments - photographic, med., opt. 4.68% 4.65% 21.47% 35.76%
4700 transportation services 3.02% 2.02% 20.50% 8.19%
4800 communications 11.30% 4.73% 12.36% 19.68%
4900 electric, gas, and sanitary services 6.94% 7.07% 4.07% 7.57%
5000 wholesale trade - durable goods 1.55% 1.84% 16.30% 13.22%
5100 wholesale trade - nondurable goods 1.34% 1.36% 11.09% 10.53%
5900 miscellaneous retail 2.22% 1.94% 20.40% 14.46%
7300 business services 4.25% 2.80% 25.65% 17.71%
8000 health services 5.57% 1.19% 22.48% 16.79%
8700 engineering & management services 4.23% 3.04% 31.98% 25.98%
Data source: Bureau van Dijk

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 The shareholder value approach

Management Value Drivers Valuation Corporate

Decisions Components Objective

• Value Growth Duration

Operating • Sales Growth

• Operating Profit Margin
• Free cash Flow
from operations
Investment • Working Capital Investment • Creating
• Fixed Capital Investment Shareholder
Value
Financing • Debt capacity • Cost of capital
• Probability of bankruptcy • Tax shields

• Tax rate, rate of inflation • Market price for risk

Parameters • Historic sales, costs, etc. • Interest rates
• Competition • Other capital market factors

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 Value drivers: value growth duration
Sustainability of competitive advantage

→ Value growth duration is the time where the company can earn economic rents.
- Abnormal returns, profitability in excess of the cost of capital
→ Positive NPV = Valuation creation.
→ Where does positive NPV come from?
- Economic “rents” from:
▪ Barriers to entry (monopolies, quotas)
▪ Special resources (mines), special knowledge (patents)
▪ Brand name and brand loyalty
→ Decompose profitability:
EBIT EBITDA − Depreciation Sales
ROA = = *
Assets Sales Assets

Net Margin Asset turnover

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 Decompose profitability

→ Decompose the return on equity as:

Net Income
ROE =
Shareholder ' s Equity
NI Sales Assets
= * *
Sales Assets Equity

Margin Asset = 1 + Debt/Equity

turnover = Leverage

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 Competition: convergence of ROA
Germany (235 companies)

20%

18%

16%

14%

12%

10%

08%

06%

04%

02%

00%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

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 Competition: convergence of ROA
United States (7496 companies)

20%

15%

10%

05%

00%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

-05%

-10%

-15%

-20%

-25%

-30%

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 The profitability cycle

Source: Koller, Goedhart, Wessels, Valuation: Measuring and Managing the Value of Companies, John
Wiley & Sons Inc., 2005, figure 6.6

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 The profitability cycle: an example

Source: Koller, Goedhart, Wessels, Valuation: Measuring and Managing the Value of Companies, John
Wiley & Sons Inc., 2005, figure 6.7

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 Threshold margin

→ The threshold margin is defined as the operating margin where the NPV of an
additional investment is zero.
- In the example in “Value Drivers - PerpetuityModel.xlsm” it is about 15.3%

Value Growth rate (real)

€194.67 0.5% 1.5% 2.5% 3.0% 3.5% 4.0%
7.0% (€64.51) (€103.94) (€180.91) (€255.40) (€397.39) (€774.52)
10.0% (€20.07) (€45.19) (€94.24) (€141.71) (€232.20) (€472.58)
Operating Margin

13.0% €24.36 €13.56 (€7.56) (€28.02) (€67.02) (€170.63)

15.3% €58.43 €58.60 €58.89 €59.15 €59.62 €60.87 Threshold
17.0% €83.60 €91.89 €108.00 €123.57 €153.23 €231.97 margin
20.0% €128.04 €150.64 €194.67 €237.26 €318.42 €533.92
21.0% €142.85 €170.22 €223.56 €275.16 €373.48 €634.57
24.0% €187.28 €228.97 €310.24 €388.85 €538.67 €936.52
27.0% €231.72 €287.72 €396.91 €502.54 €703.85 €1,238.46
30.0% €276.15 €346.47 €483.58 €616.24 €869.04 €1,540.41

→ Perfect competition drives margins to the threshold margin.

→ At threshold margin value equals capital invested (CAPEX + WC).

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 Conclusion

→ Focus on value drivers as link between managerial decisions/strategy and free

cash flows:
- Margins
- Growth
- Capital turnover
- Sustainability of competitive advantage
→ Value drivers then determine future free cash flows.
- Some need to be decomposed further.
- Components of free cash flows
→ Next step in valuation: determine the cost of capital

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