david wessels - corporate strategy and valuation

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Corporate Strategy and Valuation2011 SIFMA Securities Industry Institute

Corporate Strategy and Valuation

An Assessment of Key Value Drivers

Professor David Wessels 2011

The Wharton School of the University of Pennsylvania

3620 Locust Walk, Philadelphia PA 19104


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How Growt Dr ves Va ue In 1995, two Fortune 500 companies had $20 billion in revenue. Since then

. -

company? A or B?

AggregateRevenuesCompanyA

MarketCapitalization($billions) 146.6

60

80

10.0%

Enterprise Value($billions) 158.4

ForwardP/E(FYE'11) 18.1

PEGRatio(3yearexpected): 1.5

ROIC(viaThomsonFirstCall): 21.0%

40

$billions

4.4%

CompanyB

MarketCapitalization($billions) 31.7

Enterprise Value($billions) 34.0

0

20

1995 1998 2001 2004 2007 2010

ForwardP/E

(FYE

'11) 21.8

PEGRatio(5yrexpected): 1.2

ROIC(viaThomsonFirstCall): 9.6%

Professor David WesselsThe Wharton School of the University of Pennsylvania 27

,


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Session Overview

A valuation model of two simple companies

Although profitability metrics such as EBITDA & Earnings Per Share(EPS) correlate with value, this is not always the case. Upfront

.

The key drivers of a companys value:

The value of a com an can be traced to four ke value drivers core

operating profit, return on capital, cost of capital (risk), and organic

revenue growth.

investors, otherwise value is destroyed and share price will fall.



4/26


A Model of Two Simple Companies

CompanyA

Reinvestmentrate IR 50%

$50 million to grow thecompany. The financial staff

Returnonnewinvestment 10%

Growthinprofits 5%

pro ec s a ra e o re urn

on the new investment.

This investment leads to an

Year1 Year2 Year3

Aftertaxoperatingprofit 100.0 105.0 110.3

extra $5 million in profits.

For simplicity, we assume all

ratios, investment rate etc,. . .

Freecashflow 50.0 52.5 55.1never change.



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Which Company is Worth More? Company A and Company B currently earn $100 million in operating profit and

.

If both companies have 100 million common shares outstanding, what would

each companys earnings per share (EPS) and EPS growth rate be?

CompanyA CompanyB

Reinvestmentrate(IR) 50% Reinvestmentrate(IR) 25%

Returnonnewinvestment 10% Returnonnewinvestment 20%

Growthinprofits 5% Growthinprofits 5%

Year1 Year2 Year3 Year1 Year2 Year3

Aftertax

operating

profit 100.0 105.0 110.3 After

tax

operating

profit 100.0 105.0 110.3

NetInvestment (50.0) (52.5) (55.1) NetInvestment (25.0) (26.3) (27.6)

Freecashflow 50.0 52.5 55.1 Freecashflow 75.0 78.8 82.7



6/26


rowt : n y art o t e tory

Boston Scientific 3rd-quarter loss narrows

Bill Berkrot, Reuters

NEW YORK, Oct 21 (Reuters) - Boston Scientificreported a smaller third-quarter net loss on Tuesday as

increased sales of implantable defibrillators helped to

offset char es and a decline in sales of its dru -coated

Boston Scientific

stents.

The company's adjusted profit of 18 cents per share

topped Wall Street expectations by 2 cents, according.

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

,

expectations is a good thing," said Phillip Nalbone, an

analyst with RBC Capital Markets.

Source: Wall Street Journal

Source: Yahoo! Finance



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The Drivers of Profit Growth

Using the lessons learned from our two companies, we can create a general

relation between g (growth), IR (reinvestment rate), and ROIC (return on

invested capital).

Growth = Reinvestment * Rate of ReturnCompany A

Reinvestment Rate (IR) 50%

Return on New Investment 10%Growth in Profits 5%

=

Company B

Reinvestment Rate (IR) 25% Company A: 5% = 50% * 10%

Return on New Investment 20%

Growth in Profits 5%Company B: 5% = 25% * 20%



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e row ng erpetu ty ormu a

A company is worth the present value of its future free cash flow. For example,

Company A can be valued using:

.........55.152.550

Value32

+++=...

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

can use the rowth er etuit formula to value each com an .

.........WACC)(1

FlowCash

WACC)(1

FlowCash

WACC)(1

FlowCashValue

3

3

2

21 ++

++

++

=

gWACC

CashflowValue 1

=

via the

growing

perpetuity

rormula



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What Drives Value?

FlowCash 1gWACC But what

determines

cash flow?

As Cash Flow rises, what happens to value?

As WACC rises, what happens to value?

s grow r ses, w a appens o va ue



10/26


Der v ng t e Key Va ue Dr ver Formu a

In order to develop the key value driver formula, we rely on two simple

substitutions: the definition of cash flow and the growth, IR, and ROIC relation.

WACC

ROIC

g1Profit

WACC

IR)Profit(1

WACC

FlowCash

Value1

=

==

Cash Flow = Profit (1 IR)

Growth = IR x ROIC



11/26


The Key Value Driver Formula

Company A

ROICg1Profit

gWACC=

Com an B

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



12/26


Growth vs. Value Indices In 1992, Standard and Poor's and Barra (now MSCI) began a collaboration to produce

' - .

Through 2008, the sole criteria for the Growth/Value split was based on the market-to-book ratio for each firm.


Source: https://www.mscibarra.com/products/indices/us/performance.jsp


13/26


Whats in a Name Anyway?

,

Were companies in the growth indexgrowing?

14.0%

S&P500Histogram

3Year

Average

Revenue

Growth

of the indices by the corporate

performance center at McKinsey and

Company, the answer is no. 8.0%

10.0%

12.0%

ofS

ample

GrowthStocks

Even though growth stocks

slightly outgrow value stocks, the

difference is not significantly2.0%

4.0%

6.0%

Percen

ValueStocks

significant! The two histograms lookvery similar, and growth outgrows

value 10.1% to 8.7%.Source: McKinsey on Finance, Number 22, Fall 2007

.

1.0% 5.0% 11.0% 17.0% 23.0%



14/26


Back to Return on Capital

In actuality, it is return on capital

that distinguished the two

indices. 25.0%

S&P500Histogram

3Year

Average

ROIC

(excluding

Goodwill)

For the value index, the median

ROIC, averaged over three years,

and excluding goodwill, is only

15.0%

20.0%

tof

Sample

GrowthStocks

ValueStocks

,

percent for the growth index

The correlation of M/Bs with

0.0%

5.0%

10.0

Perce

,

versus 1 percent for growth rates.

Source: McKinsey on Finance, Number 22, Fall 2007

5.0% 10.0% 25.0% 40.0%



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A Change in Composition



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As we will show later, if the spread between ROIC and WACC is

The Growth/Value Matrix

positive, new growth creates value. The market value of a company, with a starting Profit of $100 million,

an a 10% cost o cap ta , s as o ows:

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

Professor David Wessels

The Wharton School of the University of Pennsylvania 17


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19/26


not er pp cat on: ompara es u t p es

A comparables table is a powerful tool to test the reasonableness of a

Household&PersonalCare

company s va ua on. u mos a es a o exp c y e mar e va ue o e

underlying value drivers.

EnterpriseValueComparablesAnalysis

Market Net Enterprise

Ticker Company Price Cap Debt1 Value Revenue EBITDA EBITA

RB. Reckitt Benckiser 34.53 25 063.9 18.0 25 045.9 2.9 10.5 11.1

OneYearForwardMultiples

CL ColgatePalmolive 76.24 36,799.8 3,866.0 40,665.8 2.5 9.4 10.2

PG Procter&Gamble 63.61 178,157.8 39,333.0 217,490.8 2.7 10.9 12.5

CLX Clorox 65.66 9,155.8 3,324.0 12,479.8 2.4 11.0 13.0

CHD Church&Dwight 68.75 4,890.4 407.6 5,298.1 2.0 8.9 9.9

KMB KimberlyClark 65.01 26,452.6 7,738.0 34,190.6 1.7 8.8 11.0

. . . . . . .

ENR EnergizerHoldings 67.38 4,755.9 2,205.2 6,961.1 1.5 8.6 10.0

1Debtanddebtequivalents,netofcash IndustryMean 2.3 10.0 11.2

IndustryMedian 2.4 10.4 11.0

StdDev/Mean 20.2% 9.3% 10.1%

Professor David Wessels

The Wharton School of the University of Pennsylvania 19


20/26


Va uat on Across t e In ustry

A companys valuation

should never be computed in

isolation. Always triangulate

results b com arin the RB.,2.9x

7%

8%

Revenue

Multiples

Household&PersonalCare

valuation with other

companies in the industry. CL,2.5xPG,2.7x

CLX,2.4x4%

5%

6%

arRe

venueGrowth

Multiples should rise as your

proceed to the top-right

corner. Unexpected revenue

CHD,2.0xKMB,1.7x

1%

2%

3%

Projected5

Ye

multiples should be

investigated further.

0%15% 17% 19% 21% 23% 25% 27% 29%

ProjectedEBITAMargin

20


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Appendix

21


22/26


Action

An Alternative Interpretation

gWACC

ROIC

g

1ProfitValue

= Start with the key

value driver formula.

From the definitiong

1ROICapitalC

,equals invested

capital times ROIC.gWACC

Value

=

Move ROIC inside

the brackets. gWACC

gROICCapitalValue

=

22


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Action

An Alternative Intepretation

WACC

gWACCWACCROICCapitalValue

+=

Add and Subtract

WACC in the

WACC)(ROIC Se arate the

numerator.

gWACCnumerator

+=

gWACCWACC)(ROICCapitalapitalCValue Distributeinvested capital

and were done!

23


24/26


Discounted EVA Formula

,

must be rewritten, where InvCap equals invested capital.

+=

gWACC

WACC)(ROICapitalCapitalCValue

EVAapitalCValue

TM

+=

Now, as growth rises, what happens to value?

24


25/26


26/26


Analyzing Enterprise Value Over Time

,

we can decompose enterprisevalue into invested capital, the 16,000

Clorox

ENterpriseValue

Decomposition

presen va ue o curren

performance, and the present

value of future growth. 8,000

10,000

12,000

,

millions

PV(Future

Growth)

PV(CurrentPerformance)

When the present value of future

growth is high, management has

strong expectations to meet. 2,000

4,000

6,000USD

Invested

Capital

Nonoperating

assets

This analysis is similar toanalyzing EV/EBITDA multiples.

2001 2003 2005 2007 2009 Jan

2011

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