Chapter 2 Fundamental Principles of Measuring and Managing Value Instructors: Please do not post raw PowerPoint files on public website. Thank you!

Session Overview Traditional rules of thumb about valuation can be misleading, and in some cases harmful. We start our discussion by demonstrating why EBITDA and earnings per share (EPS) often fail to measure value. In the second part of our discussion, we demonstrate how the value of a company can be traced to four key value drivers: core operating profit, return on capital, cost of capital, and organic revenue growth. –Value creation and the practice of finance are about trade-offs. Although an action can lead to an improvement in one metric (such as worker productivity), it may have an adverse impact on other metrics, such as growth or capital required. –Every business, product category, customer group, and channel must be thoroughly evaluated for the potential of growth and profitability. 2

3 Operating Profit and Free Cash Flow Company A earns $100 million a year in after-tax profit. Part of the profit will be reinvested in the business, the remainder distributed to investors. EBIT(1 − T) = $100 Reinvested in business Returned to investors $50 Investment Rate (IR) = 50% Payout Rate = 50% Financial Terms EBITDA = $180 $80 Paid in taxes

4 Operating Profit and Free Cash Flow The company plans to reinvest $50 million at a 10 percent rate of return. This investment leads to an extra $5 million in profits. For simplicity, we assume all ratios, the investment rate, and so on never change. Company A Investment rate (IR)50% Return on new investment10% Growth in profits5% Year 1Year 2Year 3 After-tax operating profit Net investment(50.0)(52.5)(55.1) Free cash flow

5 Which Company Is Worth More? Both Company A and Company B currently generate $100 million in profit and are expected to grow profits by 5 percent. If both companies have 100 million shares outstanding, what would each company’s EPS and EPS growth rate be?

6 EPS Growth: Only Part of the Story! Boston Scientific 3rd-quarter loss narrows Bill Berkrot, Reuters NEW YORK, Oct. 21 (Reuters)—Boston Scientific reported a smaller third-quarter net loss on Tuesday as increased sales of implantable defibrillators helped to offset charges and a decline in sales of its drug-coated stents. The company's adjusted profit of 18 cents per share topped Wall Street expectations by 2 cents, according to Reuters Estimates. Total net sales for the quarter fell to $1.98 billion from $2.05 billion, but that was in line with Wall Street expectations. "It was kind of an on-target quarter and right now with Boston Scientific, not falling below the range of expectations is a good thing," said Phillip Nalbone, an analyst with RBC Capital Markets. Source: Wall Street Journal, October 21, BOSTON SCIENTIFIC Stock Price

7 The Drivers of Profit Growth Before we value the two companies, let’s examine a general relationship between IR (investment rate), ROIC (return on invested capital), and g (growth). Growth = Reinvestment * Rate of Return g = IR * ROIC Company A: 5% = 50% * 10% Company B: 5% = 25% * 20% Company A Investment rate (IR)50% Return on new investment10% Growth in profits5% Company B Investment rate (IR)25% Return on new investment20% Growth in profits5%

Session Overview Traditional rules of thumb about valuation can be misleading, and in some cases harmful. We start our discussion by demonstrating why EBITDA and earnings per share (EPS) often fail to measure value. In the second part of our discussion, we demonstrate how the value of a company can be traced to four key value drivers: core operating profit, return on capital, cost of capital, and organic revenue growth. –Value creation and the practice of finance are about trade-offs. Although an action can lead to an improvement in one metric (such as worker productivity), it may have an adverse impact on other metrics, such as growth or capital required. –Every business, product category, customer group, and channel must be thoroughly evaluated for the potential of growth and profitability. 8

9 The Growing Perpetuity Formula A company is worth the present value of its future free cash flows. For example, Company A can be valued as: In our simple example, cash flows grow forever at a constant rate. Therefore, we can use the growing perpetuity formula to value each company. via the Growing Perpetuity Formula

10 What Drives Value? As cash flow rises, what happens to value? As weighted average cost of capital (WACC) rises, what happens to value? As growth rises, what happens to value? But what determines cash flow?

11 Deriving the Key Value Driver Formula In order to develop the key value driver formula, we will rely on two simple substitutions. Substitution #1 Cash Flow = Profit(1 – IR) Substitution #2 Growth = IR × ROIC

12 The Key Value Driver Formula Terminology Used by Consulting Firms Profit—After-tax operating profit (NOPAT/NOPLAT ) ROIC—Return on invested capital (ROI/RONIC/ROCE/RONA) WACC—Weighted average cost of capital (hurdle rate) g—Long-term growth in profit and cash flows

13 What Drives Value? As starting profit rises, what happens to value? As ROIC rises, what happens to value? As WACC rises, what happens to value? As growth rises, what happens to value?

14 If the spread between ROIC and WACC is positive, new growth creates value. The market value of a company with a starting profit of $100 million and a 10 percent cost of capital is as follows: The Growth/Value Matrix 7.5%10.0%12.5%15.0% 2%$917$1,000$1,050$1,083 Growth4%7781,0001,1331,222 6%5001,0001,3001,500 ROIC

15 How Growth Drives Value In 1995, two Fortune 500 companies had $20 billion in revenue. Since then one company has grown dramatically. Which company is the high-growth company, A or B? Company A Market cap ($ billion)124.3 Enterprise value ($ billion)133.6 Forward P/E (FYE '10)16.4 PEG ratio (5-year expected)1.9 ROIC (via Thomson First Call)20.0% Company B Market cap ($ billion)26.0 Enterprise value ($ billion)28.3 Forward P/E (FYE '10)21.0 PEG ratio (5-year expected)1.0 ROIC (via Thomson First Call)12.0% Source: Thomson First Call, February $ billion Aggregate Revenues 1995 − % 4.6%

16 The Value of Alternative Strategies Assume your company earns a 15 percent return on invested capital, while growing at 2 percent. The new CEO has argued that the company should grow faster, even if it means sacrificing some financial performance. What do you think? Assume your company earns a 10 percent return on invested capital, while growing at 6 percent. The new CEO has argued that the company should focus on higher- profit customers, even if it means reducing growth. What do you think? 7.5%10.0%12.5%15.0% 2%$917$1,000$1,050$1,083 Growth4%7781,0001,1331,222 6%5001,0001,3001,500 ROIC

17 As long as the spread between ROIC and WACC is positive, new growth creates value. In fact, the faster the firm grows, the more value it creates. If the spread is equal to zero, the firm creates no value through growth. The firm is growing by taking on projects that have a net present value of zero! When the spread is negative, the firm destroys value by taking on new projects. If a company cannot earn the necessary return on a new project or acquisition, its market value will drop (and often does). Creating Value: To Review