VALUATION

CONCEPTS &
METHODS
FOUNDATIONS
OF VALUE
WHY VALUE
VALUE?

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VALUE
- A helpful measure of
performance because it
takes into account the
long-term interests of
all the stakeholders in a
company.

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COMPANIES THAT MAXIMIZE VALUE
FOR THEIR SHAREHOLDERS IN THE
LONG-TERM:

Create more employment

Treat their current and future
employees better
Give their customers more
satisfaction
Shoulder a great burden of
corporate responsibility than more
shortsighted rival
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A company’s primary task is
to generate cash flows at
rates of return on invested
capital greater than the cost
of capital.

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FUNDAMENTAL PRINCIPLES OF VALUE CREATION

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GROWTH AND ROIC: DRIVERS OF VALUE
 A company’s return on invested capital and its revenue
growth together determine how revenues are converted to
cash flows.
That means the amount of value a company creates is
governed ultimately by its ROIC, revenue growth, and of
course its ability to sustain both over time.
Disaggregating a company’s cash flow into revenue growth
and ROIC helps illuminate the underlying drivers of a
company’s performance.

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RELATIONSHIP OF GROWTH, ROIC, AND CASH FLOW
Example:
Consider two companies, Value Inc. and Volume Inc., whose
projected earnings and cash flows are displayed below. Both
companies earned 100 million in year 1 and increased their
revenues and earnings at 5 percent per year, so their projected
earnings are identical.
If the popular view that value depends only on earnings were
true, the two companies’ values also would be the same.

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RELATIONSHIP OF GROWTH, ROIC, AND CASH FLOW

Example:

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RELATIONSHIP OF GROWTH, ROIC, AND CASH FLOW
Growth, ROIC, and cash flow (as represented by the investment
rate) are tied together mathematically in the following
relationship:
Investment Rate = Growth ÷ Return on Invested Capital

Applying that formula to Value Inc. =

25% = 5% ÷ 20%
Applying it to Volume Inc. =
50% = 5% ÷ 10%
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BALANCING ROIC AND GROWTH TO CREATE VALUE
• For any level of growth, value increases with
improvements in ROIC.
• When all else is equal, a higher ROIC is always good. The
same can’t be said of growth.
• When ROIC is high, faster growth increases value, but
when ROIC is lower than the company’s cost of capital,
faster growth necessarily destroys value, making the point
where ROIC equals the cost of capital the dividing line
between creating and destroying value through growth.
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CONSERVATION OF VALUE
• Anything that doesn’t increase cash flows doesn’t create value.
• Value is conserved, or unchanged, when a company changes the
ownership of claims to its cash flows but doesn’t change the total
available cash flows
Example: When a company substitutes debt for equity or
issues debt to repurchase shares
• Changing the appearance of the cash flows without actually
changing the cash flows doesn’t change the value of a company.
Example: by changing accounting techniques

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PRINCIPLES OF
VALUE CREATION

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RISK AND VALUE CREATION

• A company’s future cash flows are unknown and

therefore risky.
• Risk enters into valuation both through the company’s
cost of capital, which is the price of risk, and in the
uncertainty surrounding future cash flows
PRICE OF RISK

• Cost of capital – is the price charged by investors for bearing

the risk that the company’s future cash flows may differ from
what they anticipate when they make the investment.
• Equals the minimum return that investors expect to earn from
investing in the company.
• Also called the discount rate, because you discount future
cash flows at this rate when calculating the present value of
an investment, to reflect what you will have to pay investors.

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THE MATH OF
VALUE CREATION

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NET OPERATING PROFIT LESS ADJUSTED
TAXES (NOPLAT)
• Represents the profits generated from the company’s core
operations after subtracting the income taxes related to
the core operations.
• NOPLAT is broadly used in corporate finance as an
adjustment to the net income to represent the after-tax
cash flows available to all capital providers of a company.
• NOPLAT is an essential component of calculating free cash
flows for DCF valuations.
NET OPERATING PROFIT LESS ADJUSTED
TAXES (NOPLAT)
• Using NOPLAT, earnings can be measured without the
impact of debt servicing or leverage on a company.
• In other words, the performance of different companies
can be compared without being clouded by different
capital structures.
• NOPLAT does not include capital structure impact and
adjusts for changes in deferred taxes.
NET OPERATING PROFIT LESS ADJUSTED
TAXES (NOPLAT)
Sales 100,000.00
Cost of Sales 40,000.00
Selling, General and Admin Expense 10,000.00
Operating Income 50,000.00
Interest Expense 10,000.00
Earnings Before Income Tax 40,000.00
Income Tax Expense 10,000.00
Net Income 30,000.00

Note: P1,000 of Tax Expense is an Increase in Deferred

Taxes (Operating Cash Taxes are P9,000.
NET OPERATING PROFIT LESS ADJUSTED
TAXES (NOPLAT)

Net Income 30,000.00

Add: Interest Expense 10,000.00

After Tax Operating Profit (NOPAT) 40,000.00

Add: Change in Adjusted Taxes 1,000.00

Net Operating Profit Less Adjusted Taxes (NOPLAT) 41,000.00

INVESTED CAPITAL

Represents the cumulative amount the business

has invested in its core operations—primarily
property, plant, and equipment and working
capital.
“Capital Expenditures” or CAPEX

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NET INVESTMENT

• Is the increase in invested capital from one year to the next:

• Net investment is a good indication of how much is being invested in the

productive capacity of a company.
• If gross capital expenditures are higher than depreciation, then the net
investment will be positive, which indicates that the productive capacity of
a company is increasing.
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FREE CASH FLOW (FCF)

• Is the cash flow generated by the core operations of the

business after deducting investments in new capital.

• FCF represents the amount of cash generated by a

business, after accounting for reinvestment in non-
current capital assets by the company.

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RETURN ON INVESTED CAPITAL (ROIC)

• Is the return the company earns on each dollar invested in the

business.

• If a company generated 10 million in profits and invested an average

of 100 million in each of the past two years, the ROIC is equal to 10%.
For instance, if the ROIC is 10%, that tells us the company generates
10 of net earnings with each 100 that it invested in the company.

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EXAMPLE:

• Triumph Solutions makes a net profit of P300,000 in 2015.

Interest expense by the company in 2015 amounted to
P25,000. The total invested capital is 1,800,000 for 2015 and
1,700,000 for 2014. Calculate the ROIC for Triumph Solutions
for 2015.
ROIC = (P300,000 + P25,000)/P1,800,000 = 18.06%
FCF = (P300,000 + P25,000) – (P1,800,000 – P1,700,000)
FCF = P225,000

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THE EXPECTATIONS TREADMILL

• The performance of a company and that of its

management are frequently measured by total returns
to shareholders (TRS).
• If managers focus on improving TRS to win performance
bonuses, then their interests and the interests of their
shareholders should be aligned.
• The return on invested capital (ROIC) that a company
earns is not the same as what its shareholders earn.
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THE EXPECTATIONS TREADMILL

• To further understand the concept: Suppose a company can invest

P1,000 in a factory and earn P200 every year. The first investors in
the company pay P1,000 for their shares, and if they hold the
shares they will earn 20% per year (200 divided by 1,000).
• Suppose then, after one year, the investors decide to sell their
shares and find buyers who pay 2,000 for the shares. Because of
the higher price, and assuming it doesn't rise further, these new
buyers will earn only 10 percent per year on their investment (200
divided by 2,000), compared to the original owners who earned a
120% return.
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THE EXPECTATIONS TREADMILL

• TRS measured over periods shorter than 10 years may

not reflect the actual performance of a company and its
management.
• Improving TRS is much harder for managers leading an
already successful company than for those leading a
company with substantial room for improvement.

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THANK YOU!