The value of any stock, bond or business today is determined by

the cash inflows or outflows – discounted by an appropriate

discount rate – that can be expected to occur during the

remaining life of an asset.

- Warren Buffett, Berkshire Hathaway Annual Report (1992)

The Evolution of Value Based Management

Firm value = PV (future free cash flows).

Firm value = ΣPV t (EVA t ) + Invested Capital.

Firm value = ΣPV t (CVA t ) + Invested Capital.

EVA Stern Stewart & Co.

CVA BCG and HOLT Value Associates

Basic Notion

Firm value = PV (FCF of existing assets)+ PV (Growth opportunities)

Strategic Value Analysis LEK / Alcar

Free Cash Flow Approach

Firm’s FCF = Financing or Investors’ cash flow

Firm’s perspective

EBITDA – cash tax payments

– incremental investment in operating assets

Investor’s perspective

FCF = The amount received by investors

interest payment to creditors+ repayment of debt principal- additional debt issued+ dividends+ share repurchases- additional stock issued

Financing cash flow

1. Net working capital (CA-CL)

2. Capital expenditures and long-term assets.

Free Cash Flow& Firm valuation

FirmValue

Present value of free cash flow

Value of Non-operating assets

= ＋

- Marketable securities- Excess real state- Over funded pension plan

FirmValue

Shareholder valueFuture claim= ＋

- Interest-bearing debt- Capital lease obligations- Under funded pension plan - Contingent liabilities

Free Cash Flow Approach

Free cash flow and firm’s valuation

1. How long should we calculate? 1. CF during strategic planning period2. After strategic planning period, “residual value”• How long is strategic planning period?

2. How to forecast free cash flow? (Value drivers)- Assumption of “Value Drivers”

a) Sales growth b) Operating profit margin c) Cash tax rate d) Net working capital / sales e) Other long-term assets / sales

3. Determine the discount rate. - Based on opportunity cost.

Through value drivers, we can analyze how to improve to firm’s FCF.

Forecasting Free Cash Flow

Value driver assumptions

Case ： Ashley Corporation

Residual periodbegins

Free Cash Flow Calculations

Sales of prior year= ＄ 240,000Year 1 =(1+Sales growth rate) × Prior year sales = ( 1+0.08) × ＄ 240,000=259,200

Incremental asset investment in year t =

( Sales in year t – Sales in year t-1) × Asset-to-sales percent

Year1

Net working capital=( ＄ 259,200- ＄ 240,000) ×5.5 ％ = ＄ 1,056

Fixed assets=( ＄ 259,200- ＄ 240,000) ×40 ％ = ＄ 7,680

Other long term assets= =( ＄ 259,200- ＄ 240,000) ×2 ％ = ＄ 384

Determining the Discount Rate

【 Cost of debt×(1-Tax rate) ×Debt/Firm Value 】

7.68 ％ ×(1-0.27)=5.61 ％

＋【 Cost of equity × Equity/Firm value 】

risk free rate+ company beta × market premium

6 ％＋ (1.35×8 ％ )=16.8 ％

Weighted cost of capital

Debt 25 ％ 5.61 ％ 1.40 ％

Equity 75 ％ 16.80 ％ 12.60 ％

WACC 14.00 ％

Percentage

of capital

After-Tax

Cost

Weighted

Cost

Free Cash Flow Calculations

Planning period present value

Residual value in year T

rateGrowth -capital ofCost

1Tyear in flowcash Free

Residual value in year 10= ＄ 18,623/(0.14-0.026)=$163,36

Present value of residual CF=$163,36/(1+0.14) １０ =$44.06

Firm’s Economic value

Economic value=present value of all cash flows

= Present value of the planning period free cash flow

+Present value of the residual period free cash flow

Present value of the cash flows for year1-10 ＄ 38.52

Present value of the cash flows for the residual value ＄ 44.06

Firm’s economic value ＄ 82.58

Excess real estate 7.5

Firm value ＄ 90.08

Debt ＄ 42.00

Shareholder value ＄ 48.08

Magic Value Drivers

Threshold profit margin=7.2%

Sales growth increase

Firm value decreaseSales growth increase

Firm value increase

Myth of Growth & Firm Value

In Case Table 4.2 PV of cash flow= ＄ 82.6 million

If sales growth =0 PV of cash flow= ＄ 87.6 million

Potential value = negative 5 million

Firm value = PV (FCF of existing assets)+ PV (Growth opportunities)

Further Dissuasion of Value Driver

sensitivity Analysis of operating margin

6.00%6.00% $27,36$27,3699

--$20,71$20,71

88

6.50%6.50% 37,73137,731 --10,35310,353

7.00%7.00% 48,08448,084 00

7.50%7.50% 58,43658,436 10,35210,352

8.00%8.00% 68,78968,789 20,70520,705

8.50%8.50% 79,14179,141 31,05731,057

9.00%9.00% 89,49489,494 41,41041,410

Operating Profit Margin

Equity

Value

Change in

Base case of EV

Base case

Through sensitivity Analysis of different Value Divers

We can find the one affects firm’s value most ！

Thousands of dollars

Economic Value Road Map

Financing Decision

Investing Decision

Operating Decision

EVA is based on something we have know for a long time: what

we call profit, the money left to service equity, is not profit at all.

Until a business returns a profit that is greater than its cost of

capital, it operates at a loss. Never mind that it pays taxes as if it

had a genuine profit. The enterprise still returns less to the

economy than it devours in resources…. Until then it does not

create wealth; it destroys it.

- Peter Drucker, The Information Executives Truly Need (1995)

EVA Approach

Accounting profits v.s. Economic profits

Accounting profits

SalesCost of goods sold

Operating expenses

Interest expense

Taxes= - - - -

Economic profits

orResidual income

SalesCost of goods sold

Operating expenses

Taxes

Charge for all capital used

= -- - -

NOPATNet operating profits after taxes

FirmValue

Present value of future free cash flow

InvestedCapital

=

＋= Present value of future residual Income

Free Cash flow & Residual Income Approach

Free Cash flow & Residual Income Approach

g=7.5% g=7.5%

1. Profit margin = 6.25%

2. Retention ratio = 60%

3. Investment (WC & real) = 0.5 per dollar of sales growth

4. Cost of capital = 10%

Free Cash flow & Residual Income Approach

Residual Income: 1,250-10,000 × 10% = 250

g=7.5% g=7.5%

Free cash flow or Residual Income?

Doesn’t provide readily apparent measure of

Annual Operating performance

When Free cash flow ＜ 0

a) Investment is high in profitable firm

b) Operating is poor in unprofitable firm

e.g.Wal-Mart FCF -13% of capital, R is +8 % above its cost of capital

Kmart FCF +7% of capital, R is -3 % below its cost of capital

The weakness of free cash flow ：

Residual Income provides better measure of period performance ！

EVA Approach

EVACash flow

from operations

AccrualsAfter-tax interest

Capital charges

Accounting adjustments= + + - +

Earnings

Operation profits

Economic profits

Economic Value Added (EVA)

EVA DriversEVA Drivers

EVA = NOPAT- (k*Capital) = (r- k)*capital EVA = NOPAT- (k*Capital) = (r- k)*capital

NOPAT = operating profits after taxes but before financing NOPAT = operating profits after taxes but before financing costs and noncash bookkeeping entries except depreciationcosts and noncash bookkeeping entries except depreciation

Return on capital (r) = Return on capital (r) =

Return on capital =Return on capital =

NOPBT = firm’s net operating profits before taxesNOPBT = firm’s net operating profits before taxes

Cash taxNOPBT Sales1

Sales Capital NOPBT

NOPAT

Capital

Profit Margin

Capital Turnover Cash tax rate

EVA DriversEVA Drivers

EVA Calculation

1.Convert from accrual to cash accounting (LIFO, Bad debt reserves)2.Capitalize market-building expenditures that have been expensed in the past (R&D)3.Remove cumulative unusual losses or gains after taxes

Convert NOPAT and Capital form accounting book value to economic book value

NOPATNOPAT

CAPITALCAPITAL

Example :Hobbs-Meyer Co.Example :Hobbs-Meyer Co.

Example :Hobbs-Meyer Co.Example :Hobbs-Meyer Co.

Example: Hobbs-Meyer coExample: Hobbs-Meyer co

Finance

Equity Equivalents

Tax

Equity Equivalents

Example: Hobbs-Meyer coExample: Hobbs-Meyer co

Example :Hobbs-Meyer Co.Example :Hobbs-Meyer Co.

法一法一 EVA=NOPAT-Cost of capital* CapitalEVA=NOPAT-Cost of capital* Capital =686000-10%*3984000=288000=686000-10%*3984000=288000 法二法二 EVA=(Return on capital-Cost of capital)EVA=(Return on capital-Cost of capital) *Capital*Capital =(686000/3984000-10%)*3984000=(686000/3984000-10%)*3984000 =288000=288000

EVA V.S MVAEVA V.S MVA

Market Value AddedMarket Value Added

= Market Value of Equity - Book Value of = Market Value of Equity - Book Value of EquityEquity

= Present value of all future EVA= Present value of all future EVA

Market Value of Equity Market Value of Equity

== Book Value of Equity + Present value of Book Value of Equity + Present value of all future EVA all future EVA

EVA V.S MVAEVA V.S MVA

Positive MVA

Negative MVA

EVA VS Investment

Source: Stern Stewart Research “Special Report”,Apr,2002

相

反

EVA is closely related to EVA is closely related to NPV.NPV.

It avoids the problems associates with It avoids the problems associates with approaches that focus on approaches that focus on percentage spreadspercentage spreads( ( rate of return- rate of cost)rate of return- rate of cost)

It makes top managers responsible for a It makes top managers responsible for a measure that they have measure that they have more control overmore control over

It is influenced by It is influenced by all of the decisionsall of the decisions that that managers have to make within a firm managers have to make within a firm

Advantages of EVAAdvantages of EVA

increases in current EVA come at the increases in current EVA come at the expense of future EVAexpense of future EVA

higher EVA is accompanied by an higher EVA is accompanied by an increase in the cost of capital increase in the cost of capital

increase in EVA is increase in EVA is less than what the less than what the market expectedmarket expected it to be, leading to a it to be, leading to a drop in the market pricedrop in the market price

Side EffectsSide Effects of EVA with minimize riskof EVA with minimize risk