Mergers and acquisitions Fundamental analysis for share

valuation Evaluation of a business strategy

In the real market, a firm creates value by earning a return on invested capital greater than the opportunity cost of capital.

The more a firm invest at returns above the cost of capital, the more value it creates

A firm selects strategies that maximize the present value of expected cash flows or economic benefits

The value of a company’s shares in the stock market is based on the market’s expectations of future performance of the company.

After an initial price is set, the return that shareholders earn depends more on the changes in expectations about the company’s future performance than its actual performance.

NOPLAT (Net operating profits less adjusted taxes) represents the profits generated from the company’s core operations after subtracting the income taxes related to the core operations.

Invested capital represents the cumulative amount the business has invested in its core operations – primarily property, plan and equipment and working capital.

Invested capital is the total of equity and total borrowings in the balance sheet of a company, reduced by the amount of non-operating assets.

Net investment is the increase in invested capital from one year to the next

Net Investment = Invested capitalt+1 - Invested capitalt

FCF is the cash flow generated by the core operations of the business after deducting investments in new capital.

FCF = NOPLAT – Net Investment

ROIC is the return the company earns on each rupee invested in the business

ROIC = NOPLAT /Invested capital

IR is the portion of NOPLAT invested back into the business.

IR = Net investment/NOPLAT

WACC is the rate of return that investors expect to earn from investing in the company and therefore, the appropriate discount rate for the free cash flow

‘g’ is the rate at which the company’s NOPLAT and cash flow grows each year

If the company’s revenue and NOPLAT grow at a constant rate and the company’s IR is also constant, its FCF will grow a constant rate

Enterprise Value = FCFt+1 /(WACC-g)

FCF = NOPLAT – Net Investment

FCF = NOPLAT – (NOPLAT x IR)

FCF = NOPLAT x (1-IR)

g = ROIC x IR IR = g/ROICTechnically one should use the return on new or incremental capital

FCF = NOPLAT x (1 – IR)FCF = NOPLAT x (1-g/ROIC)

Value = [NOPLATt=1 ×(1-g/ROIC)]

WACC – gValue drivers : Growth; ROIC; and Cost of capital

The value of a company equals the amount of capital invested, plus a premium equal to the present value of the value created each year.

Economic Profit = Invested capital x (ROIC – WACC)

PV of economic profit =EP/(WACC-g)

Value = Invested capital + PV of projected EVA

Value = NOPLATT=1 x (1-g/ROIC)

WACC – g

Value = (1-g/ROIC) NOPLATt=1 WACC - g

A Company’s earnings multiple is driven by both its expected growth and its return on capital

NOPLAT = Invested Capital x ROIC

Value = Invested CapitalxROICx(1-g/ROIC) WACC - g

Value = ROICx(1-g/RONIC)Invested Capital WACC – g

Drivers are : WACC;ROIC; and g

Revenue growth Profit margin (per cent) Cash tax rate Working capital/Revenue (per cent) Capital expenditure/Revenue (per cent) Cost of capital (per cent) Value growth duration period (years)

◦ Value growth duration period represents the future period for which the entity has a foreseeable competitive advantage.