Value Creation

1. Value vs Price?

Value: relates to intrinsic qualities/worth of assets. It is a projection for future

cashflows adjusted for growth and risk, discounted to the present.

Price: is extrinsic and what the market is willing to pay. It is usually driven by
demand and supply and can be influenced by sentiment.

>> Efficient market hypothesis: On average the market correctly prices assets
leading to price = intrinsic value.

2. Trading vs Investing?

Investors: You focus on intrinsic value and hold assets for a long time believing the
market price will reflect the value defined by your asset valuation. (valuing
approach)

Traders: You focus on price and price movements and try to benefit from price
disparities and make short-term gain through investing in undervalued assets.

3. Creating value vs. Evaluating value/performance

Creating: Firms create value by generating returns on invested capital (ROIC) that
exceed
the cost of capital and maintaining it over time ROIC>WACC.

Spread: Difference between ROIC and IC. The larger the better. ROIC>WACC / IC –
Return
Volume (of investment): Growth in revenue/IC. Granted a positive yield./ IC itself
Duration (of spread): Sustaining positive spread over a longer period

Evaluating: by looking at both markets:

Real market performance (actual business), Profits/Capital deployed -> ROE,
ROA, ROIC
Financial market performance (stock price), (Dividends + price appr)/Cost to
buy shares -> TSR

>> Good companies vs Good investment: Maybe performing operationally well but
if market expectations are already high it might not be a good investment
TSR can be low even if operations are good because TSR measures performance
relative to expectations. (EVA does it on absolute basis)
4. How to sustain spread?

Some strategies: economies of scale/scope, (product differentiation trademarks,

patents, brand> monopoly due to lack of substitute), brand identity (for higher
price), Cost advantages/leadership (outsourcing like Nike or efficient distribution
channels like Avon door-to-door), capital efficiency , financial engineering

5. Book Value vs Economic Value vs Market Value (BV vs EV vs MV)?

3 ENTREPRISE ESTIMATES

BV: Book Value is the accounting value and interchangeable with IC Invested
Capital. (intrinsic)

EV: Economic Value is the present value of its free cash flows PV of FCF.
(intrinsic)

MV: Market value is the trading price based on what investors anticipate
(extrinsic)

In competitive markets, BV = EV, econ 101

In efficient market MV = EV

If ROIC < WACC , EV < BV or EV/BV < 1

ROIC = WACC ,EV = BV or EV/BV = 1
ROIC > WACC , EV > BV or EV/BV > 1

6. Overvaluation vs Undervaluation?

Over MV>EV Cheap capital leads to overinvestment> taking more risks by

managers, unrealistic expectations from market
Under MV<EV : expensive capital leads to under-investment> low asset utilization
and takeover rislk (Why issue shares at 50$ when they are worth more >
underinvestment)

>> Managers focus on maximizing EV to align with MV through, investor will only
earn oppty cost

Signaling: credible signals are usually costly like buybacks, increased dividend or
debt issuance to convey confidence

7. Law of One price?

D1 expected P 1−P0
Expected return= + =Dividend Yield+Capital Gain
P0 P0

Market price should reflect an expected return that is equal to opportunity cost

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8. Why EVA? Net Income metrics include multiple costs overlook cost of capital
while EVA includes it. A good practical proxy for value creation.
How do firms attract investors? Assure a return higher than that investors might
achieve elsewhere with an investment of similar risk (Exceed cost of capital).
Delivering the same is a zero-spread.

EVA methodology? It deduces all the routine operational costs from revenues
(inclusive of taxes) to compute a Net Operating Profit After Tax (NOPAT).

EVA = NOPAT – Charge of Capital = NOPAT – IC*WACC

EVA = (ROIC – WACC) *IC (Encompass volume and spread)

NOPAT = EBIT*(1-tax rate) --- as if firms had no debt, interests already included in
WACC

ROIC = NOPAT/WACC

***ROIC> WACC gives a positive EVA***

9. Value from shareholder’s perspective

ROE: reflects shareholder’s perspective = NI/Equity

ROE = ROA * Equity Multiple = ROA * Assets/Equity

ROE = Net Margin * Assets Efficiency*Equity Multiplier = NI/Sales *

Sales/Assets * Assets/Equity

ROE increase => Improve Profitability ex. differentiation or Assets Efficiency ex. cost
leadership (both involve operations) + Increase equity multiplier (financing leverage
by taking more debt which increases risk of shareholder)

>>>> It does not reflect what they earn by buying share and skewed down by
leverage

Earning yield =EPS/P = NI/(MV of Equity) = (NI per share)/(MV per share) =
1/(P/E)

How much you earn for every 1$ you invest

10. Why not ROE? Affected by interest expense and financing decisions/mix

Why not ROA? Affected by interest expense and financing cost

11. After-tax cost of debt

Pre-tax cost of debt = Interest rate = Interest expense/Debt

Net cost of debt = Interest (1 – tax rate) = Debt* Interest rate * (1- tax rate)

After-tax cost of debt =i’ = Net cost of debt/debt = Interest rate* (1 – tax rate) =
after-tax interestrate

ROE = ROIC + (ROIC - i’) * (D/E) (if ROIC > i' then ROE> ROIC)
Value driver Shareholder level Firm level
Spread ROE – Cost of equity ROIC - WACC
return on invested capital – wtd. average cost
of capital between cost of equity and cost of
debt
Volume of Book value of equity Book value of equity + Short-term debt +
Investment Long-term debt = Invested Capital = E+D
 Value Metrics
1. ROIC
ROIC (t) = NOPAT (t) / IC (t-1)

2. Balance Sheet Equation

A = L + E : Assets = Liabilities + Equity

A = OL + D + E: Assets = Operating Liabilities + Debt + Equity

Even more detailed:

OA + NOA = OL + D + E: Operating Assets + Non Operating Assets = Operating Liabilities

+ Debt + Equity

Or OA + NOA = OL + D + DE +E + EE

IC = OA – OL (operational approach)

IC = D+ E - NOA (financing approach) , D +E = Total fund invested

3. Equity Equivalent/Deferred Taxes:

EE: Non-cash adjustments to retained earnings

NOPAT uses cash-based taxes

4. Invested Capital

Microsoft IC = Equity + Debt(ST/LT) – Unrelated Assets (NOA) – Idle Cash

Microsoft IC= Total Assets – Unrelated Assets (NOA) – Idle Cash – NIBLS( OL +
other LT)

Financial investment are unrelated, goodwill,intangible and LT asset are other assets

Reorganize balance sheet :

A = OA(Current + Fixed + Other) & NOA L = OL (Current + Other LT) + D +DE +E +EE

A = COA + NFA +Other Assets + NOA , L = D +DE +E +EE + COL + NIBLS (Other liabilities
LT)

NIBL is a misnomer those interest were already paid

Then OA – OL | OWC(COA-COL) + NetFA +NetOtherA (OtherA – OtherLT) | Debt +

Adj Equity (E- NOA)

5. Adjustments to IC

OWC – Idle Cash + LIFO Reserves Debt +PV of operating leases

NFA (Net fixed asset) +PV of operating Adj. Equity – Idle Cash + LIFO Reserves
leases +Acc. Goodwill

Net other assets +Acc. Goodwill

 IC IC
LIFO is readded to Current Liabilities (OWC), Idle Cash deducted from Current Assets (OWC),
PV of lease is to Other LT (NFA)

Idle Cash not used in OWC

Total Cash = cash + cash equivalents + marketable securities

Excess Cash = Total Cash – Operating Cash needs

If the firm has rich growth opportunities or if R&D and capex are crucial for its success, it
may require a higher cash balance. Similarly, firms in volatile industries may need to
stockpile more cash to protect their ability to execute their plans

Sometimes use marketable securities as proxy (liquid stored in a relatively productive way)
or 5% of sales

Leases: Loan that represents a liability (restate anything before 2019)

6. NOPAT

Revenue > choose a revenue unit (Adjust by substracting unrelated business) in

IC is this revenue stream core to the business? Are the risks of the business units similar? Is
this segment recurring, indicating a long‐term commitment to it?

COGS you should add back implicit interest (lease, pensions) +

you should deduct depreciation as it represent economic wear and tear of fixed assets
simply an operating expense (since investment in tangible assets are capitalized and not
directly incurred). On the flipside amortization is expensed already immediately incurred at
acquisition. (no need to double deduct, so need to be added back) -> Add back
amortization of acquired intangible

R&D when considered as investment need to be treated as a capitalized Intangible asset(not

expense), the unamortized balance need to be added back to Invested Capital. So at
the beginning of the year we consider them as investment.

R&D/Brand Building Mktg in NOPAT would be the Amortized R&D from past investment
and do not deduct the investment for that year for that year and should not include
unamortized. Case of Cocacola who derive competitive advantadge from R&D.

Reserves need ot be added back : contra-assets, allowance or bad debt and other
provisions.

LIFO reserves is an accounting practice used in times of inflation leading to

understatement of inventory value. On top of being added back to IC the Difference between
two periods in LIFO reserves need to be added to NOPAT. (Adding to IC to reflecting true
value of inventory at today’s price).

Restructuring accounted for if recurrent, else we do not include it in NOPAT.

Adjusted cash taxes = EBIT * Marginal tax rate

Deferred tax
NOPAT += Delta(Deferred tax asset) - Delta (Deferred tax liabilities)

IC += Deferred tax liabilities – Deferred tax assets

Other Income : We do not include in NOPAT any net recognized gains or losses on
derivatives, investments, foreign currency or dividend and interest incomes or pauyments ..
minority interest “Ifnore all financing info”

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1. Market value:
MV Market Value captures external estimates of future forecasts.

MV = MV of Short Debt + MV of Long Term Debt + MV of Equity

In practice MV of Short Debt = BV of Short Debt (since rates are close to current), same for
MV of LT debt.

However, for companies in financial distress forecast payment and discount at cost of debt

MV = MV of Equity + MV of Debt

MV of Equity = #shares * share price end of t-1 – idle cash – unrelated assets

MV of Debt = BV of Debt

2. Market Added Value

Market estimate of Present Value of all future EVA. If high it is usually justified by a high
ROIC.

MVA = MV – IC = MV - (BV of Equity + BV of Debt) = PV of EVA (expected EVA from

investors)

3. Cost of Capital WACC

Re= cost of equity or the return required by equity holders

Rd = the pre-tax cost of debt or the return required by debt-holders

We adjust by (1-T)*Rd = After-tax cost of debt because interest are deductible

Cost of Equity, Re = Rf + beta [ E(Rm) – Rf]

Rf : In practice Rf uses long-term bond rates (10Y, 20Y, 30Y) to match the duration of
corporate cashflows

[E(Rm) – Rf], Market Premium: Price per unit of risk / Price of risk (usually between 5-6%)

Beta, Risk in Firm stocks, includes business risk (how cyclical rev and cost) + fin. Risk
(amount of debt)

Cost of Debt, Rd, commonly yield to maturity (overstatement) the rate that makes the PV
coupons and principal payments of the bond equal to market price of the bond (disregards
defaulting), use market rate for similar bonds (same class)

4. ROIC Tree

ROIC is the product of operating margin and asset efficiency stated on an after tax basis.

T is the cash tax rate (not effective rate or average from I/S), usually found in notes

Turns is those values over sales, ROIC is a product of the operating margin and the combined
turnover ratios of the various components of invested capital, helping us determine which
category of assets is more inefficient.

5. Breakeven Operating Margin

>>> Translating all of this to manager level

Breakeven is WACC = ROIC

WACC = (1- T) * Break-even Margin * Asset Efficiency

Break-even Margin = WACC / [(1-T)*Asset Efficiency] helps determine efficient frontier below
it value is destroyed

If Break-even margin can be achieved they can improve Asset Efficiency

Usually Low AE and High Margin for luxury, and opposite for mass market.
 =365/(D30+D32*B5-D34*B5+D36)

Valuation

Entreprise Value = Operating Assets + Unrelated Asset + Excess Cash = Debt + Equity +
Preferred Stock

EV = Market Cap + Total Dev + Preferred Stock + Minority Interest – Excess Cash

For bankers – Market Approach

EV = Operating Assets + Unrelated Asset + Excess Cash = Debt + Equity + Preferred
Stock – Excess Cash

6 APPROACHES to valuate the company:

Market Approach: based on info in the market for similar companies

1/Asset Valuation : EV = Resale Value (%BV) – If we are scrapping assets

individually

or Book Value (no spread) – When assets are mostly Working Capital, or are mostly
Fin or Real Estate

or Minimum of Replacement and DCF Value (a.k.a cost to replicate)

2/Trading Multiples: Uses stock prices at which comparables are traded

Value/Firm Characteristics , Like rev. BV earnings

Choose Multiple (Consistency Reliability Relevancy) >> Choose comparable industry,

customer or life cycle >> Adjust Company Data >> Measure/Pick the multiple
(Median, mean, high ,low)

3/Comparable Transaction : Value paid for similar firm

 (Equity + Debt) / Firm Characteristics, similar to comparable multiples

4/Real Options: Real-option valuation and decision tree analysis, more flexible approach
Where management responds to specific events that may change the course of the whole
company: internet or biotech companies

5/ DCF approach EV= FCF/WACC