Th e Va lue - Ba se d M a n a g e m e n t Fr a m e w or k
Str a te g ic
Fin a n cia l
Va lu e
Co r p o r a te
G o ve r n a n ce
Fig ur e 1 . Th e Va lue - Ba se d
M a n a g e m e n t Fra m e w or k
Valuation
3 Valuation Frameworks
Discounted Cash Flow (DCF)
Comparables
Option Value
3
3 Valuation Frameworks
Discounted Cash Flow (DCF)
Comparables
Option Value
4
DCF Valuation
Spreadsheet Approach
Economic Valuation
0
1
2
k
...
Value
PV =
n
C1
C1
(1+ k)
1
+
C2
C2
(1+ k)
2
+ ... +
Cn
Cn
(1+ k)
n
.
Capital Projects As
Cash Flow Tradeoffs
Capital
Recovery
Net
Benefits
TIME
Additional
Outlay
Initial
Outlay
Match initial investment with the combined
PV of all future cash flows
Capital Project Valuation
Annual cash flow
$20
$20
$20
$20
$20
$20
$20
1
2
3
4
5
6
10
k
Investment $100
NPV = $13
Discounting Example
Yr
1
2
3
Cash
Flow
$ 20
20
20
Discount
Factor*
.9091
.8264
.7513
P.V.
Cash Flow
$ 18.18
16.53
15.03
Cumul.
P.V.
$ 18.18
34.71
49.74
10
20
.3855
7.71
113.00
* Discount Factor = 1/(1+.10)n
Corporate Value
infinity
Value =

t=0
Cash Flowt
(1 + Cost of Capital)t
Free cash flow is the basis of value!
Investors watch this pattern……
Trend
Time
….which is “cash in and cash out”
Free cash flow = NOPAT adjusted for depreciation and other accounting elements
Less net investment in working capital, fixed assets, capitalized R&D, etc.
PLEASE DO NOT DISTURB
Working on A big project !!!
STRATEGY, PERFORMANCE
MEASUREMENT, COMPENSATION
C o rp o rate B u sin ess U n it
P V o f B u sin ess S trateg y
P lanned cash flows
D iscount factor (12% )
2001
$570
0.893
2002
$630
0.797
2003
$700
0.712
2004
$800
0.636
beyond
2005 2005
$850 $850
0.567 4.729
2000 P resent V alue
$509
$502
$498
$508
$482 $4,019
T OT AL P V
$6,519
STRATEGY, PERFORMANCE
MEASUREMENT, COMPENSATION
X YZ C o rp B u s in e s s U n it
2 0 0 5 F V o f B u s in e s s S tra te g y
P O S T -P L AN N IN G
b e yo nd
2001
2002
2003
2004
2005
2005
P la nne d ca sh flo ws
$570
$630
$700
$800
$850
$850
D isco unt fa cto r
1 .5 7 4
1 .4 0 5
1 .2 5 4
1 .1 2 0
1 .0 0 0
8 .3 3 3
2 0 0 5 F uture V a lue
$897
$885
$878
$896
$ 8 5 0 $ 7 ,0 8 3
T O T AL F V
$ 1 1 ,4 8 9
STRATEGY, PERFORMANCE
MEASUREMENT, COMPENSATION
P R E -P L AN N IN G
2 0 0 0 p re -p la nning
$600
ca sh flo w
b e yo nd
2001
2002
2003
2004
2005
2005
P la nne d ca sh flo ws
$600
$600
$600
$600
$600
$600
D isco unt fa cto r
1 .5 7 4
1 .4 0 5
1 .2 5 4
1 .1 2 0
1 .0 0 0
8 .3 3 3
2 0 0 5 F uture V a lue
$944
$843
$753
$672
$ 6 0 0 $ 5 ,0 0 0
T O T AL P R E -P L AN
F U T U R E V AL U E
$ 8 ,8 1 2
STRATEGY, PERFORMANCE
MEASUREMENT, COMPENSATION
R AN GE OF P E R F OR M AN C E
C O M P E N S A T IO N
P e rfo rm a nc e
Ta rg e t
Thre s ho ld
B us ine s s
V a lue
$ 1 1 ,4 8 9
$ 8 ,8 1 2
E xa m p le :
if b us ine s s va lue e q ua ls thre s ho ld , b o nus = 4 0 %
if b us ine s s va lue e q ua ls ta rg e t, b o nus = 1 0 0 %
Portal.com Example
T a b le 1 P o rta l.c o m F in a n c ia l S ta te m e n ts
B a la nce S he e t
2001
C a sh
2000
C ha ng e
$250
$100
$150
R e ce iva b le s
Inve nto ry
$ 2 ,6 0 0
$ 2 ,6 0 0
$ 1 ,5 0 0
$ 1 ,5 0 0
$ 1 ,1 0 0
$ 1 ,1 0 0
P ro p e rty, p la nt, & e q p t
$ 6 ,0 0 0
$ 4 ,0 0 0
$ 2 ,0 0 0
A ccum d e p re c
N e t P ro p e rty, p la nt, & e q p t
$750
$ 5 ,2 5 0
$500
$ 3 ,5 0 0
$250
$ 1 ,7 5 0
----------- ----------- ----------To ta l A sse ts
$ 1 0 ,7 0 0
$ 6 ,6 0 0
$ 4 ,1 0 0
A cco unts P a ya b le s
$ 3 ,5 7 0
$ 2 ,5 6 0
$ 1 ,0 1 0
L o ng -Te rm D e b t
$ 2 ,0 0 0
$ 2 ,0 0 0
$0
C o m m o n E q uity
$ 5 ,1 3 0 $ 2 ,0 4 0 $ 3 ,0 9 0
----------- ----------- -----------
T o ta l L ia b ilitie s & O w n e rs E qu ity
$ 1 0 ,7 0 0
$ 6 ,6 0 0
$ 4 ,1 0 0
In c o m e S ta te m e n t
S a le s
C o st o f S a le s
S e lling , g e ne ra l, a d m in
D e p re cia tio n
To ta l E xp e nse
Inte re st
Inco m e B e fo re ta x
Ta xe s (4 0 % )
N e t Inco m e
2001
$ 1 2 ,0 0 0
$ 3 ,5 0 0
$ 3 ,0 0 0
$250
-----------$ 6 ,7 5 0
$100
-----------$ 5 ,1 5 0
$ 2 ,0 6 0
-----------$ 3 ,0 9 0
F r e e C a s h F lo w s
2001
C a s h F lo w s - O pe ra tio n s
R e ve nue
$ 1 2 ,0 0 0
C a s h E xp e ns e s
$ 6 ,5 0 0
Ta xe s *
$ 2 ,1 0 0
------------
To ta l
$ 3 ,4 0 0
C a s h F lo w s - I n v e s tm e n ts
W o rk ing C a p ita l
$ 1 ,3 4 0
F ixe d A s s e ts
$ 2 ,0 0 0
------------
To ta l
$ 3 ,3 4 0
------------
N e t C a s h F lo w s
$60
A S S U M P TIO N S :
R e ve nue g ro w th
E xp e ns e g ro w th
W o rk i ng c a p i ta l g ro w th
Ta xe s g ro w th
C a p i ta l Inve s tm e nts g ro w th
T a b le 2
25%
25%
25%
25%
20%
P o rta l.c o m F re e C a s h F lo w s P ro je c tio n s a n d V a lu a tio n
2001
2002
2003
S a le s
$ 1 2 ,0 0 0 $ 1 5 ,0 0 0 $ 1 8 ,7 5 0
O p e r c o s ts e xc l. d e p re c .
$ 6 ,5 0 0
$ 8 ,1 2 5 $ 1 0 ,1 5 6
E a rni ng s b e f. d e p re c , i nte re s t, ta x (E B D IT)
$ 5 ,5 0 0
$ 6 ,8 7 5
$ 8 ,5 9 4
D e p re c i a ti o n (D e p )
$250
$300
$360
E a rni ng s b e f i nte re s t & ta x (E B IT)
$ 5 ,2 5 0
$ 6 ,5 7 5
$ 8 ,2 3 4
L e s s Ta xe s o n E B IT
$ 2 ,1 0 0
$ 2 ,6 3 0
$ 3 ,2 9 4
P lus D e p re c i a ti o n
$250
$300
$360
L e s s C a p i ta l E xp e nd i ture s
$ 2 ,0 0 0
$ 2 ,4 0 0
$ 2 ,8 8 0
L e s s A d d i ti o ns to W o rk i ng C a p i ta l
$ 1 ,3 4 0
$ 1 ,6 7 5
$ 2 ,0 9 4
F re e C a s h F l o w
$60
$170
$327
Te rm i na l V a lue (N o te 1 )
To ta l F re e C a s h F lo w
$60
NP V at 12%
le s s D e b t
E q ui ty V a lue
S ha re s o uts ta nd i ng
Intri nc i c V a lue p e r s ha re
R e c e nt S ha re P ri c e
$ 5 ,2 4 5
$ 2 ,0 0 0
$ 3 ,2 4 5
$100
$32
$29
D i s c o unt o f V a lue fro m P ri c e
11%
$170
$327
2004
2005
$ 2 3 ,4 3 8
$ 1 2 ,6 9 5
$ 1 0 ,7 4 2
$432
$ 1 0 ,3 1 0
$ 4 ,1 2 4
$432
$ 3 ,4 5 6
$ 2 ,6 1 7
$545
$ 2 9 ,2 9 7
$ 1 5 ,8 6 9
$ 1 3 ,4 2 8
$518
$ 1 2 ,9 0 9
$ 5 ,1 6 4
$518
$ 4 ,1 4 7
$ 3 ,2 7 1
$845
$545
$ 7 ,0 4 4
$ 7 ,8 9 0
Portal.com
2001 Valuation Cash Flows
Customers
$12,000 Revenue
Working Capital
Cash
150
Receivables 1,100
Inventory 1,100
Payables -1,010
-------$1,340
Cash Expense
COGS 3,500
SG&A 3,000
------$6,500
Investment
$2,000
Taxes
$2,100
Available to
Shareholders and
Debt Suppliers
$60
Company Valuation
7,044
Terminal
Value
Annual cash flow
845
545
327
170
60
k
0
1
2
3
4
5
Free Cash Flow Valuation
$0
$5,245
$2,000
$5,245
$3,245
Value of
Marketable
Market Value
Market Value of
Operating
Securities &
of Entity
Debt and other
Cash Flows
Non-operating
Cash Flows
Market Value
of
Liabilities
Equity
Adjusted Present Value (APV)
Value of financing side effects
Interest tax shields
Base-case value
APV =
Value of the project as if
it were financed with equity
Costs of financial distress
+
Subsidies
Hedges
Issue costs
APV Is Rich in Information
S o u rce o f valu e
Higher growth
Asse t sales
Wor king capital improve m
M argin impr ov eme nt
Inte rest tax shie lds
Baseline busine ss value
$0
$500
$1,000
Value cre ated
$1,500
$2,000
DCF Valuation
Formula Approaches
Company Valuation
Free Cash Flow Formulas
No growth:
V =
NOPAT0
-----------------k
Constant growth:
V =
NOPAT0(1 - b)(1 + g)
-------------------------------k - g
NOPAT0 = initial after-tax earnings before interest and taxes (EBIT)
b = rate of investment per period divided by NOPAT
g = growth in free cash flows. The subscripts s and c refer to the
supernormal growth rate and the constant growth rate.
n = number of periods of supernormal growth
k = the company’s weighted average cost of capital WACC
Company Valuation
Free Cash Flow Formulas
Temporary supernormal growth, then no growth:
V = NOPAT0 (1 - b)
n
(1 + g)t

-----------------
t=1
(1 + k)t
NOPAT0(1 + g)n+1
+
--------------------------k (1 + k)n
Temporary supernormal growth, then constant growth:
n
V = NOPAT0 (1 - b)

t=1
(1 + gs)t
NOPAT0 (1 - bs)
(1 + gs)n+1
----------------- + --------------------- x ------------(1 + k)t
k -g
NOPAT0 = initial after-tax earnings before interest and taxes (EBIT)
b
= rate of investment per period divided by NOPAT
g
= growth in free cash flows. The subscripts s and c refer to the
supernormal growth rate and the constant growth rate.
n
= number of periods of supernormal growth
k
= the company’s weighted average cost of capital WACC
(1 + k)n
DCF Approaches to Estimate Continuing Value
g=0
In a perfectly competitive market, in the long-term companies earn
their cost of capital, resulting in zero economic profit and hence
zero cash flow growth rate
g = industry
average
Zero growth rates may be too conservative in the cases of some
industries.
In that case, it is reasonable to assume that
companies’ cash flow will grow at the average industry rate
g = Forecasted
long-term
inflation
growth rate
Usually, both revenues and costs are equally affected by inflation
and hence inflation has no or little effect on a firm’s growth rate.
In some cases, especially in certain consumer industries, inflation
affects the revenues more than the costs. In this case, the
forecasted perpetual inflation growth rate is a good proxy for the
firm’s revenue growth rate and consequently its cash flow growth
rate.
g = Forecasted
long-term
GDP growth
rate
It is reasonable that in the long-term the growth rate of companies
will fade to that of the growth rate of the overall economy. If a
company grows at a sustained rate higher than that of the
economy, eventually it will become larger than the economy itself,
which of course is not possible.
Valuation Framework
V =
NOPAT
------------K
+
R - K
------------ * I * T
K
WHERE: NOPAT = NET OPERATING PROFITS AFTER TAX
K = COST OF CAPITAL
R = RETURN ON CAPITAL
I = ANNUAL INCREMENTAL INVESTMENT
T = NO. OF YEARS THAT I CAN BE INVESTED
AT R > K
V = AS IS VALUE + VALUE GROWTH OPPORTUNITIES
3 Factors in Value Creation
ROI
> WACC
Amount of Investment
Interval of Competitive Advantage
Note:
– Forward-looking
– Expected cash flows
Value Creation - Another View
Value Created = (Return On Investment
- Cost of Capital)
X Capital employed
Dependent Upon:
 Cost of Capital Spread
 Duration of Spread
 Amount of Capital Employed
Economic Profit (EP)
(R - K)
NOPAT
Operating profits
x
-
capital
K x capital
a capital charge
EP ties directly to NPV:
NPV = market value - capital
NPV = the present value of projected EP
Market value = Capital + PV of projected EP
K = WACC
R = NOPAT / Capital
Economic Profit
Discounted Cash Flow Approach:
Yr. 0
NOPAT
P.V. Perpetuity
Investment
NPV @ 10%
$2,500
($1,000)
$1,500
Yr. 1
$250
Yr. 2
$250...
Economic Profit
Discounted EP Approach:
Yr. 0
Nopat
Investment
Capital Charge
Yr. 2
$250...
$100
$100...
$150
$150...
$1,000
EP
NPV @ 10%
Yr. 1
$250
$1,500
NPV and the Regulatory Process

Remember:
NPV = Cash Inflow - Cash Outflow
where Cash Inflow = Revenues - Costs

But in a regulated environment,
Revenues = Costs + Return x Investment

Therefore, the NPV is always zero
NPV and the Regulatory Process
n
NPV =
(R - C)t
(1 + K)t

-I
t=1
but R = C + KI
n
=

t=1
(C + KI - C)t
(1 + K)t
-I
n
=

t=1
(KI)t
(1 +
K)t
-I
=
(KI)
K
-I
=
0
3 Valuation Frameworks
Discounted Cash Flow (DCF)
Comparables
Option Value
40
Comparables: An Example
MULTIPLIER
COMPANY
COMPANY
DATA
VALUE
1.5 x book value
$23.2
$34.8
9 x cash flow
$3.6
$32.4
7 x EBIT
$4.3
$30.1
25 x 2000 earnings
$1.5
$37.5
20 x 2001 earnings
$1.7
$33.0
-----------------Average Estimate
$33.6