Divestitures: Managers should devote as much time to divestitures as they do to acquisitions.

Managers should devote as much time to divestitures as they do to acquisitions.

However, managers tend to delay divesting, which leads to the loss of potential value creation.

Divestments can create value both

• around the time of the announcement and 
• in the long run.

A divestiture creates value because of the "best owner" principle whereby the old owner's culture or expertise is not well suited for the needs of the divested business.

A mature parent company divesting an innovative growth division is the typical example; however, companies ripe for divestiture could be at any stage in their life cycle.




Factors to Consider in Divesting

Considerations in divesting are

• possible losses from synergies and shared assets and systems;
• disentanglement costs, such as legal and advisory fees and fiscal changes;
• stranded costs;
• legal, contractual, and regulatory barriers; and 
• the pricing and liquidity of assets.

The costs from synergy losses, may be subtle, and existing contracts may have to be renegotiated.  

Evidence shows that the level of liquidity of the divested assets plays a role in the amount of value created.



Private or Public Transactions

Divestitures

• can be private transactions, such as trade sales and joint ventures, or 
• they can be public transactions.

Private transactions generally lead to more value creation for the seller.

Public transactions include

• IPOs, 
• carve-outs, 
• spin-offs (demergers), 
• split-offs, and 
• the issuance of a tracking stock.

Public transactions can be beneficial over the long term if the industry is consolidating.

Several types of public transactions often generate negative returns, however, and the divestiture is usually temporary

In the case of carve-outs, for example,

• the market-adjusted long-term performance for carve-out parents and subsidiaries is usually negative, and 
• usually minority carve-outs are eventually fully sold or reacquired.

Alternative Measures of Return on Capital

The primary measure of return on capital is return on invested capital (ROIC).


ROIC = net operating profit less adjusted taxes (NOPLAT) divided by invested capital.

ROIC correctly reflects return on capital in most cases, but special circumstances require alternative measures.



Intangible assets

More specifically, investments in intangible assets are expensed, which can introduce a negative bias in ROIC and lead managers to make incorrect decisions concerning how to create value.




Three issues to focus on handling such complexities

1.   When does ROIC accurately reflect the true economic return on capital?

• When does a more complex measure, such as cash flow return on investment (CFROI) make sense?

2.  How should one deal with investments in R&D and marketing and sales that are expensed when they are incurred?

• Creating pro forma financial statements that capitalize these expenses can provide more insight into the underlying economics of a business.

3.  How should one analyze businesses with very low capital requirements?

• Here it is recommended to use economic profit, or economic profit scaled by revenues, to measure return on capital.

Investments in R&D and other intangibles should be capitalized

Investments in R&D and other intangibles should be capitalized for three reasons:

• to represent historical investment more accurately
• to prevent manipulation of short-term earnings, and 
• to improve performance assessments of long-term investments.

These change only the perceptions of performance, however, and will not change the value of the firm.
Since free cash flow (FCF) includes both operating expenses and investment expenditures, capitalizing an expense will not affect FCF.



The process for capitalizing R&D

The process for capitalizing R&D has three steps:

• build and amortize the R&D asset using an appropriate asset life,
• make the appropriate upward adjustment on invested capital, and,
• make the appropriate upward adjustment on NOPLAT.

These adjustments can be applied to other expenses, such as an expansion of distribution routes.



Drawbacks of such adjustments

A couple of drawbacks of making too many such adjustments are

• the increased ability to manipulate short-term performance and 
• the incentives for managers not to recognize when to write down an asset created from a capitalized expense.

Computing Operating Taxes

In estimating value, the followings need to be determined:

• the portion of taxes due from the operating activities,
• then determine the operating cash taxes, and 
• finally, estimate the value of the corporation recognizing that some taxes are deferred.

The available information on the analyzed firm will be incomplete, therefore, operating cash taxes can only be estimated and the estimates will have errors.

Using either the company's statutory tax rate or the company's effective rate with no adjustments is not appropriate for computing operating taxes.



Adjustments for Computing Operating Taxes

1.  One suitable approach is to compute taxes as if the company were financed entirely with equity.

• To accomplish this task, begin with reported taxes and undo financing and nonoperating items one by one.
• Make estimates based on the tax rates in the various jurisdictions in which the firm operates.  

2.  Estimates of operating taxes actually paid in cash provide a better input for valuation than those estimates that include accruals.

• As part of the estimation process, subtract the increase in net operating deferred tax liabilities from operating taxes.
• Information for this process should be in the tax footnote.
• The reorganized balance sheet needs to properly assign deferred tax assets and deferred tax liabilities.

For each deferred tax account, there are four valuation methodologies:

1. value the account as part of NOPLAT,
2. value the account as part of a corresponding nonoperating asset or liability,
3. value the account as a separate nonoperating asset, and
4. ignore the account as an accounting convention.

Leases, Retirement Obligations and Receivables Accounting

Leases, pension obligations and securitized receivables are like debt obligations.

Accounting rules can allow them to be off-balance-sheet items.

Such items can bias ROIC upward, which makes competitive benchmarking unreliable.

However, valuation may be unaffected.



Operating Leases Accounting

Adjust for operating leases:

• recognize the lease as both an obligation and asset on the balance sheet (which requires an increase in operating income by adding an implicit interest expense to the income statement and lowering operating expenses by the same amount),
• adjust WACC for the new leverage ratios, and 
• value the company based on the new free cash flow and WACC  

Assuming straight-line depreciation, an estimate of a leased asset's value for the balance sheet is:

Asset Value at time t-1 = Rental Expense at time t / [ kd + (1/Life of the Asset)]

kd = cost of debt




Receivables Accounting

(a) When company sells a portion of its receivables

Another source of distortion occurs when a company sells a portion of its receivables.

This reduces accounts receivable on the balance sheet and increases cash flow from operations on the cash flow statement.

Despite the favourable changes in accounting measures, the selling of receivables is very similar to increasing debt because

• the company pays fees for the arrangement,
• it reduces its borrowing capacity, and 
• the firm pays higher interest rates on unsecured debt.

(b) Securitized receivables

In the wake of the financial crisis of 2007, accounting policy has tightened.

Securitized receivables are now classified as secured borrowing.

In these situations, no adjustment is required

In the infrequent cases where securitized receivables are not capitalized on the balance sheet,

• add back the securitized receivables to the balance sheet and 
• make a corresponding increase to short-term debt.

These alterations will determine the necessary changes to return on capital, free cash flow, and leverage.

Interest expense should increase by the fees paid for securitizing receivables.



Pension Accounting

Companies must report excess pension assets and unfunded pension obligations on the balance sheet at their current values, but pension accounting can still greatly distort operating profitability.

Three steps should be taken to incorporate excess pension assets and unfunded pension liabilities into enterprise value and the income statement to eliminate accounting distortions.  

These three steps are:

1. identify excess pension assets and unfunded liabilities on the balance sheet,
2. add excess pension assets to and deduct unfunded pension liabilities from enterprise value, and
3. remove the accounting pension expense from cost of sales and replace it with the service cost and amortization of prior service costs reported in the notes.

Much of the necessary information for this process appears in the company's notes.

Non-operating items, Provisions and Reserves

Strict accounting rules exist for dealing with nonoperating expenses and one-time charges.

For determining value, however, these entries and the financial statements require adjustments.

These entries provide relevant information concerning past performance and future cash flows.



Assessing impact of nonoperating charges

A three-step process can aid in assessing the impact of nonoperating charges:

1. reorganize the income statement into operating and nonoperating items, 
2. search the notes for embedded one-time items, and 
3. analyze each extraordinary item for its impact on future operations.

Noncash expenses usually

• lower an asset or 
• increase a provision account in the liabilities.

In evaluating a business, there are four types of provisions:

1. ongoing operating provisions,
2. long-term operating provisions,
3. non-operating restructuring provisions, and
4. provisions created to smooth income.

Reorganizing the Financial Statements

A proper assessment of financial performance requires reorganizing financial statements to avoid traps like double counting, omitting cash flows, and hiding leverage.



ROIC = NOPLAT / (Invested Capital)

FCF = NOPLAT + Noncash operating expenses - Investments in invested capital.

Invested Capital (for a simplistic firm)
= Operating Assets - Operating Liabilities = Debt + Equity

Total Funds Invested (for a more realistic firm)
= Invested Capital + Nonoperating Assets
= (Operating Assets - Operating Liabilities) + Nonoperating Assets
= (Debt + Equity) + Nonoperating Assets
= (Debt and Debt Equivalents) + (Equity and Equity Equivalents)


(NOPLAT is.Net operating profit less adjusted taxes)



In practice, there are difficulties in categorizing assets as operating or nonoperating and right-hand balance sheet items as debt or equity, and this makes computing the values in these equations difficult.

--------------------------------

Excess Cash

Excess cash should not be included in invested capital because it is not necessary for core operations, and including it will depress ROIC.

Financial subsidiaries

The operations of those subsidiaries require a separate analysis from those of the manufacturing operations, because financial institutions have different capital and leverage norms.

Advanced analytical issues

Advanced analytical issues include 

• operating leases, 
• pensions and other retirement benefits, 
• capitalized research and development, and 
• nonoperating charges and restructuring reserves.

Operating leases:  The implied value of those leased assets that are not capitalized can be estimated.  A more appropriate measure of leverage can be obtained with the following equation:

Asset Value at time t-1 = Rental Expense at time t / [kd + (1/Asset Life)]

Pensions and other retirement benefits:  Like excess cash, excess pension assets and pension shortfalls should not be included in invested capital.

Research and development:  Research and development should be included in invested capital.

Nonoperating charges and restructuring reserves:  Provisions fall into four basic categories:

• ongoing operating provisions,
• long-term operating provisions,
• nonoperating provisions, and,
• income-smoothing provisions.

Each requires an adjustment to return or invested capital or both.

Using Multiples

The use of multiples can increase valuations based on DCF analysis.

There are five requirements for making useful analyses of comparable multiples:

1. value multibusiness companies as a sum of their parts,
2. use forward estimates of earnings,
3. use the right multiple,
4. adjust the multiple for nonoperating items, and,
5. use the right peer group.

1.  Value Multibusinesses companies as a sum of their parts

Multibusiness companies' various lines of business typically have very different growth and ROIC expectations.

These firms should be valued as a sum of their parts.



2,  All Multples should use forward estimates of earnings

All multiples should be forward-looking rather than based on historical data, as valuation of firms is based on expectations of future cash flow generation.


3.  Use the Right Multiples

(a) Value-to-EBITA & P/E Multiples

The right multiple is often the value-to-EBITA ratio.

This measure is superior to the price-to-earnings (P/E) ratio because:

• capital structure affects P/E and 
• nonoperating gains and losses affect earnings.

(b) Alternative Multiples

Alternatives to the value-to-EBITA and P/E multiples include

• the value-to-EBIT ratio, 
• the value-to-EBITDA ratio, 
• the value-to-revenue ratio, 
• the price-to-earnings-growth (PEG) ratio, 
• multiples of invested capital, and 
• multiples of operating metrics.

4.  Adjust the multiples for nonoperating items

All of these ratios should be adjusted for the effects of nonoperating items.



5.  Use the right Peer Group

The peer group is important.

The peer group should consist of companies whose underlying characteristics (such as production methodology, distribution channels, and R&D) lead to similar growth and ROIC characteristics.

From Enterprise Value to Value per Share

Enterprise Value is the value of the entire company.


1.   It equals the sum of value of core operations plus value of nonoperating assets.

Enterprise Value or EV = Value of Core Operations + Value of Nonoperating assets


2.  Subtracting debt, debt equivalents, and hybrid securities, and making other adjustments, provides an estimate of the value of equity.

Value of Equity 
= EV - debt - debt equivalents - hybrid securities - other adjustments
= EV - (debt + debt equivalents + hybrid securities + other adjustments)
= Value of core operations + Value of Nonoperating assets - (Debt + Debt equivalents + hybrid securities + other adjustments).


3.  The value of equity divided by undiluted shares outstanding gives value per share

Value per share = Value of equity / Undiluted shares outstanding




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Non-operating assets

The valuation must carefully evaluate the nonoperating assets, which consist of

• excess cash and marketable securities, 
• nonconsolidated subsidiaries and equity investments, 
• loans to other companies, 
• finance subsidiaries, 
• discontinued operations, 
• excess real estate, 
• tax loss carry forwards, and 
• excess pension assets.

Debts and debt equivalent

Debt and debt equivalents consist of

• debt of all kinds (for example, bonds, bank loans and commercial paper);
• operating leases; 
• securitized receivables; 
• unfunded pension liabilities; 
• contingent liabilities; and
• operating and nonoperating provisions.

Hybrid securities

Hybrid securities consist of

• convertible debt and 
• convertible preferred stock.  

ESOS and noncontrolling interest

Employee stock options and noncontrolling interests require additional adjustments.



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Example:

A corporation has a 2 million shares outstanding.

Given the following information (all in millions), what is its value per share?

DCF of operations = $320m
Financial subsidiary value = $25m
Bonds = $185m
Discontinued operations = $2m
Securitized receivables = $4m
Operating leases = $6m


Value of Equity 
= EV - debt - debt equivalents - hybrid securities - other adjustments
= EV - (debt + debt equivalents + hybrid securities + other adjustments)
= Value of core operations + Value of Nonoperating assets - (Debt + Debt equivalents + hybrid securities + other adjustments).



Financial subsidiary value & Discontinued operations = Nonoperating assets
Bonds, Securitized receivables & Operating leases = Debt and debt equivalent


Value of Equity
= ($320 )+ ($25 + $2) - ($185 + $4 + $6)
= $150m

Value per Share
= $150 m / 2m shares 
= $75 per share.

Analysing Performance begins with an analysis of the Key Drivers of Value: ROIC and Revenue Growth.

The key drivers of value are:

• ROIC, and
• Revenue Growth.

The analysis of performance and competitive position begins with an analysis of these key drivers of value.

After having done that analysis, then do an assessment of the financial health of the firm to show whether it can make short-term and long-term investments



ROIC

It is useful to analyze ROIC with and without goodwill.


ROIC
= (1- Operating Cash Tax Rate) x (EBITA/Revenues) x (Revenues/Invested Capital)
= (1 - Operating Cash Tax Rate ) x EBITA / Invested Capital
= NOPLAT / Invested Capital



Revenue Growth

Revenue growth is one of the determinants of cash flows.

Organic revenue growth should be distinguished from growth derived from other factors such as currency effects, acquisitions, or divestitures.



-----------------------



Additional Notes:

Financial Ratios

A comprehensive model does a line item analysis, which converts every line in the financial statements into a ratio.

Ratios include common size entries computed in terms of assets or revenues for the balance sheet and income statement, respectively, and also days ratios found by the following general expression:

Days = 365 x (Balance Sheet Item / Revenues)



Efficiency Measures

Other measures provide insights into efficiency relative to other firms

One such expression is a breakdown of labour costs per unit:

Labour Expenses / Units of Output
= (Labour Expenses / Number of Employees) / (Units of Output/Number of Employees)



Power and danger of leverage

The following equation helps illustrate the power and danger of leverage

ROE = ROIC + [ROIC - (1 - T) x kd ] x D/E

T = tax rate
kd = cost of debt

It is important to note how the market debt-to-equity compares to peers in terms of the coverage and the level of risk the firm takes.

Forecasting Performance

Typically, forecasting involves making projections of cash flows to some point where the company has a steady state going forward  



The point when the Steady State going forward is reached

This steady state going forward is characterized by two properties

• the company grows at a constant rate with a constant reinvestment ratio, and 
• the company earns a constant rate of return on existing capital and new capital invested.

The Explicit Forecast Period

The horizon to the steady state, called the explicit forecast period, is usually 10 to 15 years.

This explicit forecast period should be divided into

• a first forecast period of five to seven years, where the statements will include many details,and,
• the remaining years' forecasts where the statements are simpler with less detail, which avoids the error of false precision.

Such forecasts require assumptions concerning a host of variables, including the return earned on invested capital and whether the company can stay competitive.



Steps in the Forecasting Process

There are six steps in the forecasting process.

1. Prepare and analyze historical financial statements and data.
2. Build the revenue forecast consistent with historical economy-wide evidence on growth.
3. Forecast the income statement using the appropriate economic drivers.
4. Forecast the balance sheet entries.
5. Forecast the investor funds into the balance sheet.
6. Calculate ROIC and FCF.

Additional issues include

• determining the effect of inflation,
• nonfinancial drivers, and 
• which costs are fixed and which are variable.

Estimating Continuing Value of a Company

There are two parts to the estimated value of a company based on future cash flows:

1. a portion of the value based on the initial, explicit forecast period, and,
2. a portion of the value based on continuing performance beginning at the end of the explicit forecast period.

Estimated value of a company
= Estimated Operating Value of the initial, explicit forecast period + Continuing Value beginning at the end of the explicit forecast period.


The continuing value (CV) 

• often exceeds half of the total estimated operating value, and 
• when early years have negative cash flows, the continuing value can exceed the total estimated operating value.

Two formulas for estimating continuing value

There are two formulas for estimating continuing value:

• the discounted cash flow (DCF) formula, and
• the economic-profit formula.

Other methods for estimating continuing value exist.

The convergence formula is related to the preceding formulas, for example, and it assumes that excess profits will eventually be competed away.

Some methods do not depend on the time value of money.  Those methods include

• using multiples such as P/E, 
• estimates of liquidation value and 
• estimates of replacement costs.

Valuing by Parts provides greater insights into where and how the company is generating value

Many large companies have multiple business units, each competing in segments with different economic characteristics.

Even pure-play companies often have a wide variety of underlying geographical and category segments.

If the economics of a company's segments are different, you will generate more insights by valuing each segment and adding them up to estimate the value of the entire company.

Trying to value the entire company as a single enterprise will not provide much insight, and the final valuation will likely be noisier than valuing by parts.



Valuing by parts generate better valuation estimates and deeper insights

Consider a single case where a faster-growing segment has lower returns on capital than a slower-growing segment.

If both segments maintain their ROIC, the corporate ROIC would decline as the weights of the different segments change.

Valuing by parts generate better valuation estimates and deeper insights into where and how the company is generating value.

That is why it is standard practice in industry-leading companies and among sophisticated investors.



Steps for valuing a company by its parts

Four critical steps for valuing a company by its parts are:

1. understanding the mechanics of and insights from valuing a company by the sum of its parts,
2. building financial statements by business unit - based on incomplete information, if necessary,
3. estimating the weighted average cost of capital by business unit, and 
4. testing the value based on multiples of peers.

To value a company's individual business units, you need income statements, balance sheets, and cash flow statements.

Ideally, these financial statements should approximate what the business units would look like if they were stand-alone companies.

Creating financial statements for business units requires consideration of several issues, including

1. allocating corporate overhead costs,
2. dealing with inter-company transactions,
3. understanding financial subsidiaries, and 
4. navigating incomplete public information.

Inflation

Inflation makes analyzing performance and making comparisons difficult.

Inflation usually impedes the creation of value.

Inflation lowers the value of monetary assets and the firm can rarely pass along the full effects of inflation to customers.

Typically, ROIC does not increase enough to compensate the firm for inflation.

The increase in inflation from the 1960s to the 1970s was accompanied by a decline in P/E ratios.



Periods of High Inflation

During periods of high inflation, the problem becomes much worse.

During periods of high inflation, the following distortions can occur and need to be corrected:

1. overstated growth,
2. overestimated capital turnover,
3. overstated operating margins, and 
4. distorted credit ratios.

When making forecasts in periods of high inflation, adjustments can be make in either nominal or real terms.but consistent financial projections require elements of both nominal and real forecasts.

Five steps for making forecasts in periods of high inflation are:

1. forecast operating performance in real terms,
2. build financial statements in nominal terms,
3. build financial statements in real terms,
4. forecast free cash flow in real and nominal terms, and 
5. estimate discounted cash flow (DCF) value in real and nominal terms.

Estimating the cost of capital

The weighted average cost of capital, WACC is the opportunity cost of choosing to invest in the assets generating the free cash flow (FCF) of that business as opposed to another business of similar risk.

For consistency, the estimate of the WACC should have the following properties:

1. it includes the opportunity cost of all investors,
2. it uses the appropriate market-based weights,
3. it includes related costs/benefits such as the interest tax shield,
4. it is computed after corporate taxes, 
5. it is based on the same expectations of inflation as used in the FCF forecasts, and 
6. the duration of the securities used in estimating the WACC equals the duration of the FCFs.

Given:
D/V = target weight in debt
E/V = target weight in equity
kd = required return of debt as source of capital
ke = required return of equity as source of capital
Tm = marginal tax rate

WACC = D/V * kd (1 - Tm) + E/V * ke



Cost of equity

The capital asset pricing model (CAPM) is a popular way to estimate the cost of equity.

It includes an estimate of

• the risk free rate, 
• beta, and 
• the market risk premium.

Estimated equity risk premium
= risk free rate + Beta x (market risk premium)
= risk free rate + Beta x (market risk - risk free rate)


Note:  there are alternatives to the CAPM such as the Fama-French three factor model and the arbitrage pricing theory.


Cost of debt

The after tax cost of debt requires

• an estimate of the required return on debt capital and 
• an estimate of the tax rate.

Other estimates include the weights in the target capital structure and, when relevant, the effects of debt equivalent and the effects of a complex capital structure

The Alchemy of Stock Market Performance - Total Returns to Shareholders

Total Returns to Shareholders

Decomposing total returns to shareholders (TSR) can give better insights into a company's true performance and in setting new targets.

The traditional method decomposes TRS into three parts:

1. percent change in earnings
2. percent change in P/E, and, 
3. dividend yield.

A clearer picture can be found from breaking TRS into four parts:

1. the value generated from revenue growth net of the capital required to grow
2. the growth in TRS that would have taken place without the measure in (1),
3. changes in shareholder's expectations about the company's performance as reflected in a measure such as P/E, and
4. the effect of leverage.

A good company and a good investment may not be the same.

Example:

Comparing the company and stock performance of Reckitt Benckiser Group (RB) and Henkel from 2008 to 2013

Revenue growth and ROIC:   RB outperformed Henkel in both

Annualised TRS:  RB 19% and Henkel 932%)

Explaination:  Henkel's low starting multiple in 2008 reflected difficulties with its adhesives business, which experienced significant declines in sales volume in 2008 and 2009.




Expectation treadmill

This is the name for a problem faced by high-performing managers who try to meet market expectations that result from the high level of performance in recent periods.

RB above, illustrates the reason that, in the short term, extraordinary managers may deliver only mediocre total returns to shareholders.

Lesson derived (for investors and managers):  A small decline in TRS in the short run to adjust expectations (P/E) may be preferable to desperately trying to maintain TRS through acquisitions and ill-advised ventures.



Summary:

For periods of 10 - 15 years or more, it is true that if managers focus on improving TRS to win performance bonuses, then their interests and the interests of shareholders should be aligned.

The detrimental result of the expectations treadmill is that, for firms that have had superior operating and TRS performance, the managers who try to continually meet the higher expectations may engage in detrimental activities such as ill-advised acquisitions or new ventures.

A company should measure management performance in terms of the company's performance, not its share price.

Three areas of focus should be its performance relative to its peers in its::

• growth,
• ROIC, and 
• TRS,

Conservation of Value and the Role of Risk. Increasing value through reducing the company's risk and its cost of capital.

Cash flow drives a firm's value creation.

Growth and ROIC generate cash flow.



Value creation

Companies create value:

• when they grow at returns on capital greater than their cost of capital or 
• when they increase their returns on capital.

Actions that don't increase cash flows over the long term will NOT create value, regardless of whether they improve earnings or otherwise make financial statements look stronger.

One Exception:  reducing the company's risks or its cost of capital can create firm's value

Actions the company takes to reduce a company's risk and therefore, its cost of capital.

There are different types of risk and it is important to explore how they enter into a company's valuation.

Only risk reductions that reduce a company's nondiversifiable risk will reduce its cost of capital.

How good is the company in creating value for its shareholders? How much value can it create?

The chief measures for judging a company are

• its ability to create value for its shareholders and 
• the amount of total value it creates.

Corporations that create value in the long term tend to increase

• the welfare of shareholders and employees 
• as well as customer satisfaction.

 They tend to behave more responsibly as corporate entities.


Value Creation

Value creation occurs when a company GENERATES CASH FLOWS AT RATES OF RETURN THAT EXCEED THE COST OF CAPITAL.

Accomplishing this goal usually requires that the company have a COMPETITIVE ADVANTAGE.

Strengthening its competitive advantage also creates value in the long run.



Activities that do not create value

Activities such as leverage and accounting changes do not create value.

Frequently, managers shortsightedly emphasise earnings per share (EPS).

• A poll of managers found that most managers would reduce discretionary value-creating activities such as research and development (R&D) in order to meet short-term earnings targets.
• One method to meet earnings targets is to cut costs, which may have short-term benefits but can have long-run detrimental effects.

Fundamental Principles of Firm's Value Creation

Value creation is determined by cash flows.

Cash flows are driven by 

• revenue growth and 
• return on invested capital (ROIC).

For any given level of revenue growth, increasing ROIC increases value.

However, increasing revenue growth does not always increases the firm's value.

• When ROIC is greater than the cost of capital, increasing growth increases the value of the firm.
• When the ROIC is less than the cost of capital, increasing growth decreases the firm's value.
• When ROIC equals the cost of capital, growth does not affect a firm's value.

The Stock Market is Smarter than We Think

The only 2 drivers of value creation are:

1. Return on Invested Capital (ROIC) 
2. Growth

Return on invested capital (ROIC) and growth are the only drivers of value creation.



Activities that do not drive value creation

Managers often spend time and resources attempting to:

• smooth earnings, 
• meet earnings targets,
• stay listed in a stock index,  
• become cross-listed,
• change the accounting rules, and 
• do stock splits.

The evidence shows that the stock market does not reward these efforts.  

Changes in accounting rules and stock splits do not have lasting effects.

ALL the above issues do not have an effect on stock returns unless they reflect a change in fundamental value.

Listing and delisting from an index and cross-listing

Listing and delisting from an index do not seem to have long-term effects for any given firm.

Although there can be a negative effect initially from delisting, the effect usually reverses in a few months.

Furthermore, cross-listing within developed markets does not have an effect; however firms in emerging markets may benefit from cross-listing in a developed market.



Accounting Changes

Investors apparently see through accounting changes.

If investors focused on earnings, for example, a move from FIFO to LIFO would lower the share price, but it generally does the opposite because of the increase in cash flows.

Another example, mere changes in goodwill do not affect share price; however, a change in goodwill that is associated with a real change in the firm produces a reaction from sophisticated investors.




Mispricing in the Market

Two possible sources of mispricings are:

1. the combinations of overreaction, underreaction, reversal and momentum, and
2. bubbles and bursts.

Unrealistic expectations of continued growth, which led to excessively high P/E ratios, caused the tech bubble in the late 1990s.

High earnings that were not sustainable caused the credit bubble a decade later.  In this case, it was not that the P/E ratios were too high, but that the earnings in the ratio eventually had to fall.

The basic source of value creation is competitive advantage. A High ROIC is the result of a Competitive Advantage.

A High ROIC is the result of a Competitive Advantage


The basic source of value creation is competitive advantage.

A high ROIC is the result of a competitive advantage from

• being able to charge a higher price or 
• being able to produce at a lower cost.

A strategy model for competitive advantage (Porter's framework)

A structure-conduct-performance framework provides a strategy model for competitive advantage.

One of the most widely used approaches in analyzing strategy is Porter's framework, which focuses on

• threat of entry,
• pressure from substitute products,
• bargaining power of buyers,
• bargaining power of suppliers, and,
• the degree of rivalry among existing competitors.

These forces differ widely by industry.



Five pricing advantages and Four cost advantages

Five pricing advantages and four cost advantages determine overall competitive advantage.

The five pricing advantages are:

• innovative products,
• quality,
• brand,
• customer lock-in, and,
• rational price discipline.

The four cost advantages are

• innovative business methods, 
• unique resources,
• economies of scale, and,
• scalable products/processes.

Pricing and cost advantages can erode through competition

In a competitive economy, the pricing and cost advantages can erode through competition.

The sustainability of the high ROIC from a competitive advantage depends on issues such as

• the length of the life cycle of the business and 
• the potential for renewing products.

Relative ROIC of a firm is fairly sustainable for periods of 10 years or more.

The evidence shows that the relative ROIC of a firm to the average of all other firms and to the firms in the industry remains fairly sustainable for periods of 10 years or more; however, there will be some reversion to the median and/or mean.




Additional Notes:


ROIC

=   NOPLAT / Invested Capital

= {(1- Tax Rate) * [Price per Unit - Cost per Unit]}/Invested Capital per Unit


NOPLAT = Net Operating Profit less Adjusted Tax

This formula explains how a higher ROIC is the result of a competitive advantage from being able to charge a higher price or being able to produce at a lower cost.