P.V. VISWANATH FOR A FIRST COURSE IN VALUATION 2 Earnings and Cashflows Showing how ROIC forecasts depend upon the competitive structure of the industry. Discussion of the sources of competitive advantage. Showing how forecasts of Net Investment need to be derived from forecasts of Capital Efficiency ratios. Showing how to use forecasts of capital efficiency, revenue growth and operating margin to come up with a consistent firm valuation. 3 Earnings are not the same as cashflows. Earnings numbers (such as Net Income) are constructed to answer questions, such as – what was the profitability of the firm this period? Such questions may be important for various purposes – one to construct incentive-compatible compensation packages; two, to help in forecasting future profitability, which is preliminary to decisionmaking on whether to continue or discontinue projects or enterprises. Accounting rules help normalize earnings over time by distributing revenues and expenses fairly over time. For this purpose, we need to use various accounting principles, such as the matching principle, which will assign costs to revenues and other principles governing revenue recognition that will assign revenues and costs to specific time periods. 4 Revenues are recognized when the service for which the firm is getting paid has been performed in full or substantially, and the firm has received in return either cash or a receivable that is both observable and measurable. For expenses that are directly linked to the production of revenues (like labor and materials), expenses are recognized in the same period in which revenues are recognized. Expenses that are not directly linked to the production of revenues are recognized in the period in which the firm consumes the services. But still, there is a basic difference between accounting earnings and cashflows! 5 A dollar of accounting earnings cannot necessarily be paid out as dividends or used up otherwise in that period. For example, there might have been revenue generation, but the money might not have been collected! This means that we cannot directly use earnings to compute the increase in the present value of the firm and the increase in the wealth of the firm’s stakeholders. If the objective of the firm is taken to be maximization of the firm’s market value or the wealth of the firm’s equity-holders, we need to take another tack. The market for corporate and treasury bonds provide a direct valuation in today’s dollars of future dollars that are available for consumption in those future periods. Hence if we can estimate the cashflows generated by a firm in future periods, we can compute the present value of those future cashflows. Any activities that increase that present value is then desirable. Cashflows, thus, can be used as a direct guide to valuation and indirectly to rational decision-making. 6 However, as argued before, it is earnings that will allow us to determine the profitability of a firm in a given period. On the other hand, we need cashflows to compute the value of the firm. How do we resolve this seeming contradiction? The answer is that we use both. We use accounting numbers as a guide to forecasts of future profitability and future earnings. We then use rules to take us from earnings numbers to cashflow numbers. We then discount future cashflows using appropriate discount rates. Thus we use earnings in their place and cashflows in their place! 7 There are two basic elements that we have to worry about – inflows and outflows. As far as outflows are concerned, accountants distinguish between operating expenses – outlays that yield benefits only in the immediate period (such as labor and materials for a manufacturing firm) and capital expenditures – those that yield benefits over multiple periods (such as land, buildings, and long-lived assets). Operating expenses are subtracted from income in the period in which they are incurred. Capital expenditures are spared out over multiple periods and deducted as an expense in each period. These expenses are called depreciation (for a tangible asset) or amortization (for an intangible asset). Since the actual cash outlay occurs at the beginning when the capital expenditure is incurred, for cashflow purposes, we must recognize the capital expenditure at the time of incurring; and, at the same time, add back the depreciation/amortization which is charged to income over time because there is no cash outflow at that time. 8 As far as inflows are concerned, under the accrual system of accounting, revenues are recognized when the sale is made rather than when the customer pays. Obviously, the second date is more relevant for cashflows than the first date. The problem is that if the two dates are different, accrual revenues differ from cash revenues. There are four possibilities: Customers who bought their goods in prior periods may pay in this period – this will reduce accounts receivable (current asset) and hence decrease Non-Cash Working Capital. Net Income less change in Non-Cash Working Capital is positive. Customers who buy their goods in this period may defer payment to future periods – this will increase accounts receivable (current asset) and hence decrease Non-Cash Working Capital. Net Income less change in N0n-Cash Working Capital is zero. Customers may pay in advance for products that will not be delivered until future periods – this will increase unearned income (current liability). This is not recognized in Net Income at all, and the net effect on Net Income less change in N0n-Cash Working Capital is positive. Customers who buy goods and services may never pay – this is treated in the next slide. 9 Suppose $1000 of sales this period are estimated to be uncollectible. First, accounts receivable will go up to the tune of all credit sales (including the $1000). Then, the allowance for uncollectible accounts will be increased by $1000 and Uncollectible Accounts will be charged $1000. This has several effects. On the income statement, revenues of $1000 will be offset by the Uncollectible Accounts expense and the effect will be zero. On the balance sheet, the increase in the allowance for uncollectible accounts of $1000 will be shown as a deduction from accounts receivable and hence the net effect will be zero. For our purposes, the total amount of cash received for the $1000 sale is zero and this is reflected in a zero effect on Net Income less change in Non-Cash Working Capital. If the customer actually pays, the original decrease (when the account was deemed uncollectible) in Accounts Receivable is reversed and Allowance for Uncollectible Accounts is decreased. Then the payment is recognized by a decrease in Accounts Receivable and an increase in cash. The change in Non-Cash Working Capital is now negative (because the net effect on A/R is negative) and Net Income less change in NonCash Working Capital is positive. (Ultimately, this happy event flows through directly to Retained Earnings without affecting the income statement.) When the account is actually written off, the allowance for uncollectible accounts is decreased and Accounts Receivable increased so the net effect on current assets is zero, which is appropriate since there is no cashflow at all. Schaum's Outline of Financial Accounting 2 Ed. By Jae K. Shim, Joel G. Siegel, p. 175-6 10 What we see in all these cases is that Net Income less change in Non- Cash Working Capital moves us from the accrual system to a cash accounting system, which is what we desire. Similarly, other deviations from cashflow due to the accrual system of accounting (such as operating expenses and other outflows that are not cash transactions) are taken into account by adjusting earnings by the change in non-cash working capital. We see, thus, that there are three kinds of modifications that need to be made to earnings: One, change in non-cash working capital Two, capital expenditures (defined broadly as any long-term investment) Three, adding back non-cash charges such as depreciation; this is often done by netting it out from capital expenditures. Since an increase in non-cash working capital (such as an increase in accounts receivable) can also be thought as resources tied up that could have been used profitably elsewhere, changes in non-cash working capital represent changes in invested capital. The sum of changes in non-cash working capital and capital expenditures gives us the aggregate change to Invested Capital. 11 In order to value the company, it is necessary to forecast Free Cashflow and discount it to the present. Free Cashflow is defined as NOPLAT - Increases to Invested Capital = NOPLAT – Capital Expenditures + Depreciation – Changes in Non-Cash Working Capital NOPLAT broadly speaking can be defined as Revenues less Costs less Taxes. We can proceed to forecast Revenues and Costs separately and even forecast the components of these two budget categories. However we must keep in mind that there are two other issues with which these forecasts must be kept consistent. One, our ROIC forecasts must be consistent with the competitiveness of the firm within the industry. Two, our assumptions regarding Net Investments over time must be consistent with our efficiency in using our assets. 12 It is important to keep in mind in making assumptions regarding Operating Income is that Sales and Income cannot change in a vacuum. Unless a firm has a monopoly, competitors actions and reactions have to be taken into account. As long as an industry is profitable, there will be an incentive for new competitors to enter the industry and for existing competitors to intensify their efforts. Ultimately, this means that in the long run, ROIC will tend to be equal to WACC. If ROIC is much less than WACC, existing firms will exit the industry and if ROIC is greater than WACC, new firms will enter the industry. However, this does not mean that every firm in the industry will have to operate with a ROIC figure close to WACC. 13 While there is general pressure for ROIC to be close Percent to WACC, the specific situation depends very much on each firm. Competitive Pressure Peak ROIC Sustainability WACC Years 14 What is common to all firms striving to maximize value is the ability to keep ROIC as high as possible and higher than WACC for as long as possible. When competitive pressures get too strong to be able to bear, ROIC tends back down to WACC. The way in which ROIC can be kept higher than WACC is by exploiting competitive advantages. In the short run, ROIC can be kept high by developing new strategies that are more innovative in generating customer wants and/or cheaper production techniques. In this sense, this is not a zero-sum game. Alternatively, the firm can increase value by competing head-on against competitors. Ultimately, though, in the long-run, this is a zero-sum game, because the innovative actions of individual firms will themselves increase expected returns. What can a firm do to increase its competitive advantage? 15 The availability of economies of scale in production Investments that are structured to exploit economies of scale are more likely to be successful than those that are not. Product differentiation Investments designed to create a position at the high end of anything, including the high end of the low end, differentiated by a quality or service edge, will generally be profitable. Cost advantages Investments aimed at achieving the lowest delivered cost position in the industry, coupled with a pricing policy to expand market share, are likely to succeed, especially if the cost reductions are proprietary. Monopolistic access to distribution channels Investments devoted to gaining better product distribution often lead to higher profitability. Protective government regulation Investments in project protected from competition by government regulation can lead to extraordinary profitability. However, what the government gives, the government can take away! 16 ROIC (1 T ) (Unit Price Unit Cost) x Quantity InvestedCapital Another way of recognizing the sources of value is to consider the above reworking of the Zen Formula. This shows that for individual firms to have high ROICs, year in and year out for many years, there must be an advantage in one of three areas: Price Cost Capital Efficiency 17 In commodity markets, companies are price takers. There is very little difference between the product offered by one company and that offered by another. The production cost thus directly determines the sales price. To enable price setting, a company must find a way to differentiate its product from its competition. For example, Coca Cola is a price setter and can charge a price well in excess of its marginal costs. This is because customers choose soft drinks based on taste, preference and brand image. Coca Cola Customers are loyal and do not switch brands even when faced with a low-priced alternative. 18 ROIC for Coca-Cola 700% 600% 500% 400% 300% ROIC 200% 100% 0% Computed from data for Coca-Cola by Prof PV Viswanath 19 Question: Why did Coca-Cola’s ROIC drop after 1999-2000 to such a low level? 20 Another way to obtain a high ROIC is to sell products and services at a lower cost than the competition. Wal-Mart is an example. It is know for using its substantial purchasing volume to lower its costs and force better terms from its suppliers. The company invests heavily in computing power and technology to improve its cost position; thus, it stands at the forefront of RFID, a new technology to keep track of inventory. Chinese apparel firms also have cost competitiveness. However, over time, labor costs in China will increase and erode their competitiveness relative to perhaps other firms located in Vietnam. 21 Tom Copeland tells of achieving capital efficiency in a firm that he consulted for: The client had constructed poles that were thicker and closer than required by engineering standards, and with thicker cable. When asked the reason for such a strong distribution system, the reply was that a strong system was better able to resist wind damage from tree limbs during storms. It turned out that it was more value effective to use less thick poles and cables and simply trim the trees more often. This caused profit to drop, but the drop in required capital was even lower and resulted in higher ROIC. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=717744&downl oad=yes 22 Even if profits per transaction are low, a company can generate value by selling more products per dollar of invested capital than its competition. In the airline industry, an aircraft generates revenue when it is transporting passengers, not when it sits on the ground empty. Thus, the more an airline flies each aircraft in a given day, the more value it can create. Southwest Airlines has a single kind of airplane, allowing for cost savings in maintenance, but also advantages in flexibility, since all aircraft can be used for all flights. By spending more on getting aircraft serviced quickly, the total number of aircraft necessary can also be reduced, thus increasing capital efficiency. 23 At this point, we have made our ROIC forecasts. Now, we make our forecasts regarding NOPLAT (i.e. Operating Income). We have to ensure that these are consistent with our assumptions regarding Invested Capital. It is not possible to increase operating income without either increasing the efficiency of use of existing assets or increasing the amount of invested capital. Hence if there are no clear avenues to increasing the efficiency of existing assets, invested capital must increase to be consistent with assumptions of increased operating income. We have to make sure as well that assumptions regarding increased sales are consistent with the productivity of the assets used in the generation of those sales. 24 How do we do this? First we forecast ROIC based on assumptions regarding the competitiveness of the firm within the industry, as discussed above. We also need to make assumptions regarding revenue growth and after-tax operating profit margin, using the modified Dupont Analysis already discussed. Finally, we need to make assumptions about the terminal growth rate and the cost of capital. We are now ready to value the firm. 25 Suppose you have made the following forecasts for the next seven years: Base Year Forecast Revenue Growth After-tax Op Margin 0.025 Capital Efficiency 1.053 ROIC 1 2 3 4 5 6 7 15% 14% 13% 12% 11% 10% 9% 3% 6% 8% 20% 16% 12% 8% 1 3% 1 6% 1.1 9% 1.1 22% 1.1 18% 1.2 14% 1.2 10% 26 Year Base Yr 1 2 3 4 5 6 7 Revenues 1000 1150 1311 1481.43 1659.20 1841.71 2025.89 2208.21 Operating Profits 25 34.5 78.66 121.48 331.84 302.04 237.03 183.28 Invested Capital 950 1150 1311 1346.75 1508.37 1674.29 1688.24 1840.18 Free Cashflow -165.5 -82.34 85.72 170.23 136.12 223.08 31.34 We first use forecasts of revenue growth to compute revenues in all years. We then use the estimate of Operating Margin to obtain Operating Profits. The Capital Efficiency Estimates are then used to obtain the required Invested Capital each period. Finally, the change in Invested Capital is added to Operating Profits to yield Free Cashflow. 27 Assuming a cost of capital of 10% and a terminal growth rate in FCF of 5%, we can compute the terminal value of the enterprise, as of year 7 as (31.34)(1.05)/(0.10-0.05) = $658.15 The present value of this quantity is 658.15/(1.1)7 = $337.73 The sum of the present values of the cashflows for the first 7 years can be computed in a straightforward way using the 10% discount rate as $188.69. The sum of these two quantities, which is $526.43 is the enterprise value.