Chapter 2

Fundamental Principles of
Measuring and Managing Value
 Session Overview

• Traditional rules of thumb about valuation can be misleading, and in

some cases harmful. We start our discussion by demonstrating why
EBITDA and earnings per share (EPS) often fail to measure value.

• In the second part of our discussion, we demonstrate how the value of

a company can be traced to four key value drivers: core operating
profit, return on capital, cost of capital, and organic revenue growth.

– Value creation and the practice of finance are about trade-offs. Although an action can
lead to an improvement in one metric (such as worker productivity), it may have an
adverse impact on other metrics, such as growth or capital required.

– Every business, product category, customer group, and channel must be thoroughly
evaluated for the potential of growth and profitability.

2
 Operating Profit and Free Cash Flow

• Company A earns $100 million a year in after-tax profit. Part of the profit will
be reinvested in the business, the remainder distributed to investors.

Paid in taxes
$80
EBITDA
= $180
Financial Terms
$50
Reinvested Investment Rate (IR) = 50%
in business
EBIT(1 − T)
= $100 $50
Payout Rate = 50%

Returned
to investors

3
 Operating Profit and Free Cash Flow

• The company plans to Company A

reinvest $50 million at a Investment rate (IR) 50%
10 percent rate of return. Return on new investment 10%

• This investment leads to Growth in profits 5%

an extra $5 million in
profits. Year 1 Year 2 Year 3

• For simplicity, we assume After-tax operating profit 100.0 105.0 110.3

Net investment (50.0) (52.5) (55.1)
all ratios, the investment
Free cash flow 50.0 52.5 55.1
rate, and so on never
change.

4
 Which Company Is Worth More?

• Both Company A and Company B currently generate $100 million in profit

and are expected to grow profits by 5 percent.
• If both companies have 100 million shares outstanding, what would each
company’s EPS and EPS growth rate be?

Company A Company B

Investment rate (IR) 50% Investment rate (IR) 25%

Return on new investment 10% Return on new investment 20%

Growth in profits 5% Growth in profits 5%

Year 1 Year 2 Year 3 Year 1 Year 2 Year 3

After-tax operating profit 100.0 105.0 110.3 After-tax operating profit 100.0 105.0 110.3

Net investment (50.0) (52.5) (55.1) Net investment (25.0) (26.3) (27.6)
Free cash flow 50.0 52.5 55.1 Free cash flow 75.0 78.7 82.7

5
 EPS Growth: Only Part of the Story!

Boston Scientific 3rd-quarter loss narrows

Bill Berkrot, Reuters

BOSTON SCIENTIFIC NEW YORK, Oct. 21 (Reuters)—Boston Scientific

Stock Price reported a smaller third-quarter net loss on
Tuesday as increased sales of implantable
defibrillators helped to offset charges and a
decline in sales of its drug-coated stents.

The company's adjusted profit of 18 cents per

share topped Wall Street expectations by 2 cents,
according to Reuters Estimates. Total net sales
for the quarter fell to $1.98 billion from $2.05
billion, but that was in line with Wall Street
expectations.

"It was kind of an on-target quarter and right now

with Boston Scientific, not falling below the range
of expectations is a good thing," said Phillip
Nalbone, an analyst with RBC Capital Markets.

Source: Wall Street Journal, October 21, 2009.

6
 The Drivers of Profit Growth

• Before we value the two companies, let’s examine a general

relationship between IR (investment rate), ROIC (return on invested
capital), and g (growth).

Company A
Investment rate (IR) 50% Growth = Reinvestment * Rate of Return
Return on new investment 10%
Growth in profits 5%
g = IR * ROIC
Company B
Investment rate (IR) 25% Company A: 5% = 50% * 10%
Return on new investment 20%
Growth in profits 5%
Company B: 5% = 25% * 20%

7
 Session Overview

• Traditional rules of thumb about valuation can be misleading, and in

some cases harmful. We start our discussion by demonstrating why
EBITDA and earnings per share (EPS) often fail to measure value.

• In the second part of our discussion, we demonstrate how the value of

a company can be traced to four key value drivers: core operating
profit, return on capital, cost of capital, and organic revenue growth.
– Value creation and the practice of finance are about trade-offs. Although an action can
lead to an improvement in one metric (such as worker productivity), it may have an
adverse impact on other metrics, such as growth or capital required.

– Every business, product category, customer group, and channel must be thoroughly
evaluated for the potential of growth and profitability.

8
 The Growing Perpetuity Formula

• A company is worth the present value of its future free cash flows. For
example, Company A can be valued as:

50 52.5 55.1
Value    . . .
(1.10) (1.10) 2 (1.10) 3

• In our simple example, cash flows grow forever at a constant rate.

Therefore, we can use the growing perpetuity formula to value each
company.
Cash Flow1 Cash Flow 2 Cash Flow 3
Value    . . .
(1  WACC) (1  WACC) 2 (1  WACC) 3
via the
Cash Flow1 Growing
Value  Perpetuity
WACC  g Formula

9
 What Drives Value?

Cash Flow1
Value 
WACC  g But what
determines
cash flow?
As cash flow rises, what happens to value?
As weighted average cost of capital (WACC) rises, what happens to value?
As growth rises, what happens to value?

10
 Deriving the Key Value Driver Formula

• In order to develop the key value driver formula, we will rely on

two simple substitutions.

 g 
Profit 1  
Cash Flow1 Profit(1  IR)  ROIC 
Value   
WACC  g WACC  g WACC  g

Substitution #1 Substitution #2
Cash Flow = Profit(1 – IR) Growth = IR × ROIC

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 The Key Value Driver Formula

 g 
Profit1  
 ROIC 
Value 
WACC  g

Terminology Used by Consulting Firms

Profit—After-tax operating profit (NOPAT/NOPLAT )
ROIC—Return on invested capital (ROI/RONIC/ROCE/RONA)
WACC—Weighted average cost of capital (hurdle rate)
g—Long-term growth in profit and cash flows

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 What Drives Value?

 g 
Profit1  
 ROIC 
Value 
WACC  g

As starting profit rises, what happens to value?

As ROIC rises, what happens to value?
As WACC rises, what happens to value?
As growth rises, what happens to value?

13
 The Growth/Value Matrix

• If the spread between ROIC and WACC is positive, new growth

creates value.
• The market value of a company with a starting profit of $100
million and a 10 percent cost of capital is as follows:

ROIC
7.5% 10.0% 12.5% 15.0%

2% $917 $1,000 $1,050 $1,083

Growth 4% 778 1,000 1,133 1,222

6% 500 1,000 1,300 1,500

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 How Growth Drives Value

• In 1995, two Fortune 500 companies had $20 billion in revenue. Since
then one company has grown dramatically. Which company is the
high-growth company, A or B?

Aggregate Revenues Company A

1995−2009 Market cap ($ billion) 124.3

80 Enterprise value ($ billion) 133.6

Forward P/E (FYE '10) 16.4
12.0% PEG ratio (5-year expected) 1.9
ROIC (via Thomson First Call) 20.0%
60
$ billion

Company B
40
Market cap ($ billion) 26.0
Enterprise value ($ billion) 28.3
4.6%
Forward P/E (FYE '10) 21.0
20 PEG ratio (5-year expected) 1.0
ROIC (via Thomson First Call) 12.0%

0 Source: Thomson First Call, February 2010.

1995 1998 2001 2004 2007

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 The Value of Alternative Strategies
ROIC
7.5% 10.0% 12.5% 15.0%

2% $917 $1,000 $1,050 $1,083

Growth 4% 778 1,000 1,133 1,222

6% 500 1,000 1,300 1,500

• Assume your company earns a 15 percent return on invested capital, while growing
at 2 percent. The new CEO has argued that the company should grow faster, even
if it means sacrificing some financial performance. What do you think?
• Assume your company earns a 10 percent return on invested capital, while growing
at 6 percent. The new CEO has argued that the company should focus on higher-
profit customers, even if it means reducing growth. What do you think?

16
 Creating Value: To Review

• As long as the spread between ROIC and WACC is positive,

new growth creates value. In fact, the faster the firm grows, the
more value it creates.
• If the spread is equal to zero, the firm creates no value through
growth. The firm is growing by taking on projects that have a
net present value of zero!
• When the spread is negative, the firm destroys value by taking
on new projects. If a company cannot earn the necessary
return on a new project or acquisition, its market value will drop
(and often does).

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