Strategic Financial Management

Session 5 & 6

VBMS• In VBM companies, shareholder value creation is the only objective

– Value creation is typically measures using an economic profit or residual income metric (such as EVA), given the amount of total capital used to generate that profit

– These metrics and their value drivers are solely used to evaluate business performance

– Target setting (at all levels of organisation) are based on measures that can be affected by employees, and focus is on value drivers that simulate value creation

– Bonuses are based upon changes in metric (EVA)• What VBMS does not do

– VBM does not solve the problem of using different financial measures– In practice, it is adopted differently at different org levels, and measured in

various ways– It does not lead to decentralisation or empowerment of business units

Models to Measure Value Creation

• Marakon Model• Alcar Model• Mckinsey Model

Marakon Model

• The model highlights three primary financial drivers of value– Returns/profitability: The company’s profitability

as measured by its RoE and its RoI– Growth: The growth rate of the company’s capital,

which reflects growth in revenue, and for a given RoE and RoI, drives earnings growth• g = reinvestment rate x RoE

– Risk: The company cost of capital – its cost of equity and its WACC

Marakon Model• The model measures a firm’s market value to book value ratio, and links

it to RoE, CoE and growth rate of capital– The price/book ratio is the ratio of the market value of equity to the book value

of equity– PB ratio = MV of Equity / BV of Equity

• Going back of a simple DDM– P0 = D1/(r – g) = EPS0 x payout ratio x (1 + g) / (r-g)

– P0 /BV0 = (EPS0/BV0) x payout ratio x (1+g) / (r-g)

– PB0 = RoE x payout ratio x (1+g) / (r – g) current RoE– PB = RoE x payout ratio / (r – g) Forward RoE

• Conclusions– A firm’s MV is higher than its BV only if RoE is greater than CoE (r) – When RoE > CoE, the higher the value of growth rate (g), the higher is its MV to

BV ratio

Marakon Model

• Calculate MV/BV for the firm with:– RoE = 20%– g = 8%– CoE = 10%

• What happens to this ratio if RoE declines to 15% and g to 5% in the next two years?– What does this means about “earnings quality”

Marakon Model

• The last example highlights that there is a fourth strategic driver of value, which is sustainability (of profitability, growth, risk control)

• Sustainability depends upon:– Economic attractiveness of the market in which the

company operates • this determines market’s average equity spread (RoE – CoE) and

growth over time

– Competitive advantage of the company in the market• This determines company’s relative equity spread and relative

growth over time

Marakon Model

• Summary: A firm can maximise its shareholder value by focusing on both earnings quantity and quality by:– Understanding financial drivers: investing capital as

much capital as possible at rates of return that exceed the cost of capital

– Understanding strategic drivers: Investing capital to improve company’s strategic position by entering more attractive markets and building competitive advantages

– Formulating strategies focus on the above two– Aligning management’s interest with firm’s interest

Alcar (SVA) Model• Developed by Rappaport in 1986• Alcar model uses DCF to identify value creating strategies• Value of the strategy is the difference between the post-strategy

market value and the pre-strategy market value of firms strategy• Alcar approach has seven value drivers

– Annual growth rate of sales– Operating profit Margin– Income tax rate– Incremental Working capital– Incremental investment in fixed assets– Value growth duration– Cost of capital

Alcar Model• Value of Operations = PV of

FCF during value growth duration + PV of FCF after value growth duration (residual value or terminal value)

• Business Valuation = Value of operations + value of marketable securities & investments – Value of debt

• For terminal value, it is assumed that the firm is in steady state and its RoC = CoC

FCF Calculation

Alcar Model

• Infogain is in the business of providing software development and data management primarily for BFSI segment. The company was established in 2007 and spent the first three years in developing its product portfolio, comprising of web products, desktop applications, content, and web management.

• The company has just come off development stage and is leveraging its broad suite of products to rapidly grow its sales. Sales grew 143% y-o-y to Rs36.4mn in FY10, and are expected to grow 134% in FY11. Considering the company is in an expansion phase of its life cycle, high growth in sales and profits is projected over the next 5-10 years.

• Key Assumptions in Model are:– 1. Sales CAGR of 45% over the period FY10-FY15– 2. EBITDA margin to improve from 2% in FY10 to 22% in FY11 to 45% in FY15.

The improvement will be driven by rationalization of employee and administrative costs in the backdrop of rising product sales

– 3. Capex over the forecast period will remain in the range of 7%-9% of sales or 15%-25% of EBITDA to support sales growth

– 4. Cost of Equity is assumed to be 24.5% (beta of 2.0) during FY11-FY12 and then decline to 18% (beta of 1.4) by FY15 to reflect the growing acceptance of the company’s products. For the calculation of Terminal valuation, cost of equity (and capital) is assumed to be 15%. Cost of debt will be 9% in the forecast period.

– 5. In the constant growth phase assumed for terminal value calculation, growth is projected to be 8% and reinvestment rate of 10% of EBITDA.

• Determine the value of the company based on Alcar model– Test sensitivity of equity value based on Alcar value drivers

Alcar Model

• SVA can be used for business valuation as well as evaluating alternative business strategies

• Sensitivity analysis is possible as the model has a simplified approach with only seven value drivers– The seven key drivers can be broken down into more detailed &

practical performance measures and targets• Disadvantage lies in predicting variables required in the

analysis

Mckinsey Model• Mckinsey is a comprehensive approach to value-based

management. According to it, key steps in maximising value of a firm are:– Management’s goal is shareholder value maximization– Identification of the value drivers– Development of strategy– Setting of targets– Deciding upon action plans– Setting up the performance measurement system– Implementation

Mckinsey Model – Key features• Use of published accounting data as input

– Historical ratios are used as a starting point for making predictions for the same ratios in future

• Values equity of a going concern– Asset side is valued first. Value of interest-bearing liabilities is then

subtracted to get value of equity• Current liabilities are part of operations, not financing• Deferred income taxes are viewed as part of equity

– Value of asset side = value of operations + excess marketable securities– Operations of the firm is valued by discounting FCF from operations using

WACC• FCF is forecasted for explicit forecast period, at least 7 –10 years; forecast period

should be long-enough to capture transitory effects, such as take-over, turnaround, major product/service launches

• FCF is calculated from forecasted income statements and balance sheet

Mckinsey Model – Key features

• Terminal or continuing value is calculated from an infinite discounting formula (e.g. Gordon growth) – FCF in post-forecast period increases by some constant percentage every year

• Mckinsey model is comprehensive so as to model all possible value drivers

DCF Approach

• In discounted cash flow valuation, the value of an asset is the present value of the expected cash flows on the asset

• Philosophical Basis: Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk

• Information Needed: To use discounted cash flow valuation, you need– to estimate the life of the asset– to estimate the cash flows during the life of the asset– to estimate the discount rate to apply to these cash flows to

get present value

DCF Valuation

• A publicly traded firm potentially has an infinite life. The value is therefore the PV of future cash flows

• Since we cannot estimate cash flows forever, we estimate cash flows for a “growth period” and then estimate a terminal value, to capture the value at the end of the period:

DCF Choices: Equity valuation vs. Firm valuation

Firm Valuation: Value the entire firm

Equity valuation: Value just the equity claim in the business

Equity Valuation

Firm Valuation

Measuring Cash Flow

Calculating FCFE/FCFF • 1. Estimate FCFE

– Net income: Rs125 cr– Capital spending: Rs150cr– Depreciation: Rs50 cr– Increase in non-cash working capital: Rs 50 cr– New debt proceeds: Rs 75 cr; No change in old debt

• 2. Estimate FCFF for the above firm if total debt outstanding was Rs500cr and average interest rate on debt was 10%. Tax rate for the company is 30%.

• In cases where leverage (DR or Debt to capital ratio) of the company is stable, FCFE is calculated as– Net income – (1-DR) x (Capex – Depr) – (1-DR) x Chg in WC Capital = FCFE– For such a firm, proceeds from new debt issues = Principal repayments + DR x (capex – Depr + Δ Working

Capital)• 3. Estimate FCFE

– Net income: Rs125 cr– Capital spending: Rs150cr– Depreciation: Rs50 cr– Increase in non-cash working capital: Rs 50 cr– Debt to capital ratio: 25%

Estimating Cash Flows

• Estimate the current earnings of the firm– If looking at cash flows to equity, look at earnings after interest

expenses - i.e. net income– If looking at cash flows to the firm, look at operating earnings after

taxes• Consider how much the firm invested to create future growth

– If the investment is not expensed, it will be categorized as capital expenditures. To the extent that depreciation provides a cash flow, it will cover some of these expenditures.

– Increasing working capital needs are also investments for future growth

• If looking at cash flows to equity, consider the cash flows from net debt issues (debt issued - debt repaid)

Generic DCF Valuation Model

DCF Valuation• Estimate the discount rate or rates to use in the valuation

– Discount rate can be either a cost of equity (if doing equity valuation) or a cost of capital (if valuing the firm)

– Discount rate can be in nominal terms or real terms, depending upon whether the cash flows are nominal or real

– Discount rate can vary across time.• Estimate the current earnings and cash flows on the asset, to

either equity investors (CF to Equity) or to all claimholders (CF to Firm)– Estimate the future earnings and cash flows on the firm being valued– Estimate when the firm will reach “stable growth” and what

characteristics (risk & cash flow) it will have when it does.• Choose the right DCF model for the asset and value it

Discount Rates

• Discount rate should be consistent with both the riskiness and the type of cashflow being discounted– Equity vs. Firm– Cost of Equity: Higher for riskier investments and lower for safer

investments• Only systematic risk is rewarded as investors are well-diversified• CAPM: Cost of Equity = Riskfree rate + Equity beta x Equity Risk Premium

– In practice: Govt security rates are used as risk-free rates– Historical risk premiums are used as risk premium– Beta is estimated by regressing stock returns against market returns

– Cost of Capital: Weighted average of Cost of Equity and Cost of Debt• Cost of debt is the interest rate at which the company can borrow currently• Weights are market values of debt and equity

Which Growth Pattern to Use• If firm is

– large and growing at a rate close to or less than growth rate of the economy, or – constrained by regulation from growing at rate faster than the economy– has the characteristics of a stable firm (average risk & reinvestment rates)

Use a Stable Growth Model• If firm

– is large & growing at a moderate rate (≤ Overall growth rate + 10%) or– has a single product & barriers to entry with a finite life (e.g. patents)

Use a 2-Stage Growth Model• If firm

– is small and growing at a very high rate (> Overall growth rate + 10%) or– has significant barriers to entry into the business– has firm characteristics that are very different from the norm

Use a 3-Stage or n-stage Model

DCF Models

• Free Cash Flow to Equity model• Free Cash Flow to Firm Model

FCFE• In the strictest sense, the only cash flow that an investor will receive from

an equity investment in a publicly traded firm is the dividend that will be paid on the stock.

• Actual dividends, however, are set by the managers of the firm and may be much lower than the potential dividends (that could have been paid out)

• When actual dividends are less than potential dividends, using a model that focuses only on dividends will under state the true value of the equity in a firm

• The potential dividends of a firm are the cash flows left over after the firm has made any “investments” it needs to make to create future growth and net debt repayments (debt repayments - new debt issues) i.e. Free Cash Flow to Equity– Free Cash flow to Equity = Net Income - (Capital Expenditures - Depreciation) -

Changes in non-cash Working Capital - (Principal Repayments - New Debt Issues) – Pref Dividends

Dividend vs FCFE

• Use the Dividend Discount Model– (a) For firms which pay dividends (and repurchase stock)

which are close to the Free Cash Flow to Equity (over a extended period)

• Use the FCFE Model– (a) For firms which pay dividends which are significantly

higher or lower than the Free Cash Flow to Equity. (What is significant? ... As a rule of thumb, if dividends are less than 80% of FCFE or dividends are greater than 110% of FCFE over a 5- year period, use the FCFE model)

– (b) For firms where dividends are not available (Example: Private Companies, IPOs)

Equity Valuation with FCFE

Valuing a Firm

Valuation example• Mayrond is an apparel company that owns 80% of White Stores, a

retail firm. You have been able to obtain both the fully consolidated and parent company financials for Mayrond Textiles, with the following information (in millions). Estimate the value of equity per share

Parent (Mayrond Only) Fully ConsolidatedEBIT 750 1250Tax Rate 40.0% 40.0%RoC 10.0% 12.5%Expected Growth Rate 3.0% 3.0%Cost of capital 9.0% 9.0%Debt 2000 2500

200 million shares outstanding

Estimating Terminal Value

Stable Growth and Terminal Value• When a firm’s cash flows grow at a ‘constant’ rate forever, the PV

of those cash flows can be written as:– Value = Expected Cash Flow Next Period / (r – g) where,

r = Discount rate (CoE or CoC)g = Expected growth rate

• This constant growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the firm operates

DCF Valuation example

• Calculate the value of equity using FCFF and FCFE DCF method

Cost of Equity 13.5%

Cost of Debt 10.0%

Tax Rate 30.0%

Total Debt 8000

Current Market Value of stock 15293

CF to firm stable growth rate 3.2%

CF to Equity stable growth rate 5.0%

Year Cash Flow to Equity

1 1000

2 1200

3 1380

4 1518

5 1639

Value Creation – DCF approach

• Increase cash flows from existing operations– Divestitures/liquidation– Cost-reductions– Reduce tax burden– Reduce net capex– Reduce non-cash working capital as a % of

revenue• Increase expected growth

Value Creation – DCF approach

• Lengthen the period of high growth• Reduce the cost of financing

EVA Case Study

• Is EVA a good measure of financial performance for cyclical and capital intensive industries?

• Three options– Diversification in unrelated

industry– Diversification in related industry– Product mix (value-added

products)– Capacity addition?– Productivity improvement?

EVA CalculationOperating Profit (EBIT) 17.96Other Charge 2.29Tax Rate 20%NOPAT 12.57

Invested Capital 85.66 Cost of Capital 10.7%Capital Charge 9.17

EVA 3.40

Appendix

Fundamentals of GrowthInvestment in existing projectsRs 1000

XCurrent Return on Investment

on project, 15%

= Current Earnings, Rs150

Investment in existing projectsRs 1000

XCurrent Return on Investment

on project, 10%

Investment in new

projectsRs 100

XReturn on

Investment on new project,

15%

+ =Next

Period’s Earnings,

Rs165

Reinvestment Rate: 100 / 150 = 66.6%

Return on Investment = 15%

Growth Rate in Earnings: (165/150)-1 = 10%

X =

If RoI is not expected to change from year to year, the growth in earnings will come solely from new investments (and expected RoI on it)

Fundamentals of Growth• If return on existing assets increases (from 15% to 16%), then

expected growth rate will be– (1000 * (16% - 15%) + 100 * 16%) / (1000 * 15%) = 17.33%

Expected growth = Growth from new investments + Efficiency growth

• Using the same logic, expected long-term growth in EPS can be written as– Reinvestment rate = Retained Earnings / Current Earnings = Retention

ratioReturn on Investment = Return on Equity

In case, current ROE is expected to remain unchanged,gEPS = Retention ratio * ROE

Fundamentals of Growth• A more general version of expected growth in earnings can be obtained by

substituting in the equity reinvestment into real investments (net capital expenditures and working capital):

Equity Reinvestment Rate = (Net Capital Expenditures + Change in Working Capital) (1 - Debt Ratio)/ Net Income

Expected Growth in Net Income = Equity Reinvestment Rate * ROE

• When looking at growth in operating income, the definitions are

Reinvestment Rate = (Net Capital Expenditures + Change in WC)/EBIT(1-t)Return on Investment = ROC = EBIT(1-t)/(BV of Debt + BV of Equity)

• gEBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC

or gEBIT = Reinvestment Rate * ROC

Fundamentals of Growth

• In stable growth period, can there be growth from effficiency gain?– Reinvestment rate = stable growth rate / stable

period Return on Capital• Can Return on capital be higher than cost of

capital in stable period?– Some firms (typically large, well-managed firms)

do better at sustaining excess returns for longer periods (McKinsey & Co)

VBMS

• In summary, key elements of VBMS are– Aims to create shareholder value– Identifies value drivers– Connects performance measurement, target

setting and rewards to value creation or value drivers

– Connects decision making and action planning, both strategic and financial, to value creation and value drivers