Analysing a company's future performance and estimating its value

Analysing a company's future performance and estimating its value 

• begin with examining historical and current data and 
• then making projections.

Several sets of forecasts or scenarios

Several sets of forecasts or scenarios should be made using different assumptions concerning

• the business environment and 
• the strategy of the firm.

A simple example is where only two or three scenarios are created, example,

• a business-as-usual scenario,
• an aggressive marketing or acquisition scenario, and 
• an operational improvement scenario.

Estimating Value

The value should be estimated using

1. various explicit forecast horizons and
2. different methods.

1.  Estimating Value using Various explicit forecast horizons

There are usually two periods to forecast:

• the explicit forecast period and 
• the period after that in which the challenge is to estimate the continuing value for that period.

2.  Estimating Value using Different methods

There is also the choice of using these methods for estimating value:

• the free cash flow (FCF) method and 
• the economic-profit method.

Both methods should be used and their results compared.

By estimating value using different explicit forecast horizons and methods,

• the robustness of the model and 
• the consistency of the assumptions can be verified.

Valuation Model should be tested for Validity and Sensitivity to Various Inputs and Economic Forecasts

Once the valuation model is complete, it should be tested for its

• validity, 
• sensitivity to various inputs and 
• sensitivity to various economic forecasts.

(a)  Validity

A model's validity can be questioned if there are mechanical errors or flaws in economic logic.


(b)  Sensitivity to Various Inputs and Economic Forecasts

Understanding how sensitive the valuations are to key input and economic conditions gives a more robust understanding of

• the long-term value drivers for a firm and 
• the potential for large swings in value.

Checks and Balances

Verifying valuation results involves checks and balances to see if the model is technically robust by addressing the following relationships:

• that the balance sheet balances and the correct relationships exist among income, retained earnings, and dividends;
• that the sum of invested capital plus nonoperational assets equals the cumulative sources of financing; and 
• that the change in excess cash and debt line up with the cash flow statement.

A good model will have automatic checks for these relationships.


Economic Consistency

Checking for economic consistency involves seeing if the results reflect appropriate value driver economics; for example, high growth and return should be reflected in value of operations higher than book value.

Check also to see if the patterns of key financial and operating ratios are consistent with economic logic and in general, check to see if the results are plausible.


Sensitivity Analysis

Sensitivity analysis aids in determining the impact of changes of key drivers, and scenario analysis allows for assessing results under a broad set of conditions.

Valuation can be very sensitive to small changes in assumptions, which is why market values fluctuate.

A good guide is to aim for a valuation range of +/- 15%, which is similar to the range used by investment bankers.

Flexibility: The inclusion of flexibility into the analysis is generally more relevant in the valuation of individual businesses and projects.

Net present values (NPVs) calculated from single cash flow projections may be inadequate because they do not take into account the ability to expand or scale back.



Here is a simple example.  

A firm can scale back by eliminating a negative cash flow project after the first period.

There is a 60% probability of $20 per year forever or 40% probability of -$6 per year forever.

The discount rate is 10%.


Without an option to cancel

If the initial cost today is $100, then without an option to cancel, the NPV would be:

-$100 + 0.6 x ($20/0.10) + 0.4 x (-$6/0.10) = -$4


With an option to cancel after the first year

With the option to abandon after the first year, the NPV would be:

-$100 + 0.6 x ($20/0.10) + 0.4 x (-$6/1.10) = $17.82


The value of the option to cancel the project is the difference, or $21.82



Conclusion:

The inclusion of flexibility into the analysis is generally more relevant in the valuation of individual businesses and projects.

The real-option valuation (ROV) and decision tree analysis (DTA) are the two primary methods of valuation.

• Both depend on forecasting based on contingent states of the world.
• Although ROV is often a better methodology to use than DTA, it is not the right approach in every case.

Three common approaches employed in the stock market: Value investing, Growth Investing and Technical Investing

There are essentially 3 types of investing employed in the stock market, namely:

1. value investing
2. growth investing
3. technical investing.

Value investing was taught by Benjamin Graham.

Growth investing was shared by Philip Fisher.

Warren Buffett started off as a strict value investor of Benjamin Graham type.  He has since incorporated a lot of Philip Fisher's teaching into his investing.

In effect, Warren Buffett teaches that value and growth investing are essentially different sides of a same coin.  What is investing if not value investing, that is, buying something for less than its intrinsic value?

Value investing and growth investing are most suited for those with a long term investing horizon.

Most successful long term investors are essentially value investors.

They hold long term portfolios that have compounded in values over a long period of investing.

Technical investing are employed mainly by those with short term focus in their investing.  

The majority of traders in the market are technical "investors".




Additional notes:

Fundamental analysis is both qualitative and quantitative.

In fact, in my practice, qualitative is the more important analysis.

The ability to understand the business ensures that you are investing in a great company within your circle of competence.

Some combine the fundamental with the technical, and feel that they have an edge when doing so.

Personally, technical analysis has played little role in my investing so far.

Corporate Portfolio Strategy. Constructing a portfolio of businesses.

Each firm should manage its portfolio of businesses by determining whether it is the best owner of each business in the portfolio.

• That is, whether it can create the most value from each business it owns.
• If so, then the firm should keep the business.
• If not, the firm should divest the business for a value that exceeds its value to the firm.

It should use the same basic philosophy when considering adding businesses to the portfolio.

Firms that can add the most value to a business usually have one of five advantages:

1. unique links with other businesses within the firm,
2. distinctive skills, 
3. better governance,
4. better insight and foresight, and 
5. an influence on critical stakeholders.

The firm that can offer one or more of these advantages can change over time as the firm, business, or economy changes.

• At the beginning of a business, for example, the founders are the best managers, but this will usually change.
• The needs of the business change as it expands and needs additional capital, a wider variety of management skills, and more connections to other businesses such as buyers and suppliers.
• A typical path of a business begins with the founders and end in a conglomerate corporation.

When constructing a portfolio of businesses, the firm should take five steps:

1. assess the gap between a firm's current value and its as-is-value,
2. identify internal opportunities to improve operations,
3. determine if some businesses in the firm should be divested,
4. identify potential acquisitions or the initiatives to create new growth, and 
5. assess if the company's value can increase from changes in capital structure.

Diversification considerations are not part of the list.

• The purported benefits of diversification are illusive, while the costs are real.
• For instance, diversification can hurt the value of the firm it it lowers the ability of the managers to focus on how to create value for each of the various businesses.

Cross-Border Valuation

U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) have been converging over time.

The valuation of companies and subsidiaries in foreign countries has become easier.

Four issues need to be considered when analyzing foreign companies:

1. making forecasts in foreign and domestic currencies,
2. estimating the cost of capital in a foreign currency
3. incorporating foreign-currency risk in valuations, and 
4. using translated foreign-currency financial statements

For a given company, forecast the cash flows in the most relevant currency.

Use either the spot-rate method or the forward-rate method to convert the value of the cash flows into that of the parent company.

It is important to use consistent monetary assumptions in the process (e.g., concerning inflation and interest rates).

When estimating the cost of capital, use the equity premium from a global portfolio without an adjustment for currency risk.

When translating statements into another currency, there are three choices:

1. the current method, 
2. the temporal method, and,
3. the inflation-adjusted current method.

Using, the current method is the most appropriate approach.

Valuing High Growth Companies

The recommended standard valuation principles apply to high-growth companies too.

There is a difference in the order of the steps of the valuation process and the emphasis on each step.

1.  The analyst should forecast the development of the company's markets and then work backward.

2.  The analyst should create scenarios concerning the market's possible paths of development.

3.  When looking into the future, the analyst should also estimate a point in time at which the company's performance is likely to stabilize and then work backward from that point.

4.  By then, the company will have captured a stable market share; and one part of the forecasting process requires determining the size of the market and the company's share.

5.  Then, the firm must estimate the inputs for return:  operating margins, required capital investments, and ROIC.

6.  Finally, the analyst should develop scenarios and apply to the scenarios a set of probability weights consistent with long-term historical evidence on corporate growth.




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Time  ------->

Today ..... Rapid Growth ...... Growth Stabilizes .......

Today .....Growing Market Share .....Stable Market Share

Today..... How big is the market? .... How big is the market and the company's share?


Calculating the return:

1.  What is its total revenue?
2   What are its operating margins?
3.  What are its net operating profit after adjusting for tax?
4.  What are its capital investments?
5.  Calculate its ROIC

Valuing companies in Emerging Markets

Valuation is usually difficult in emerging markets.

There are unique risks and obstacles not present in developed markets.

Additional considerations include

• macroeconomic uncertainty, 
• illiquid capital markets, 
• controls on the flow of capital into and out of the country, 
• less rigorous standards of accounting and 
• disclosure, and high levels of political risk.

To estimate value, three different methods are used:

1. a discounted cash flow (DCF) approach with probability-weighted scenarios that model the risks the business faces,
2. a DCF valuation with a country risk premium built into the cost of capital, and 
3. a valuation based on comparable trading and transaction multiples.

For developed nations, the analyst must:

• develop consistent economic assumptions,
• forecast cash flows, and 
• compute a WACC.

Computing cash flows, however, may require extra work because of accounting differences.

If done correctly, the two DCF methods (1 and 2 above) should give the same estimate of value.

Valuing Banks

There are four complications in the valuation of banks:

1. the latitude managers have with respect to accounting decisions,
2. lack of transparency,
3. the level of leverage, and 
4. the fact that banks are multibusiness companies.

Those businesses include

1. borrowing and lending,
2. underwriting and placement of securities,
3. payment services, 
4. asset management, 
5. proprietary trading, and 
6. brokerage.

DCF on operations approach is not appropriate

In valuing a bank, a discounted cash flow (DCF) on operations approach is not appropriate because interest rates revenue, and costs, are part of operating income.



Equity DCF method is more appropriate

The equity DCF method is more appropriate, and the analyst should triangulate the results with a multiples-based valuation.

The equity approach uses a modified version of the value driver formula in which

• return on equity (ROE) and return on new equity (RONE) replace ROIC and RONIC, and 
• net income replaces NOPLAT:

Current Value at time t = Net Income at time t+1  *  [1 - (g/RONE)] / ke - g

ke = cost of equity


Problems and complications in bank valuations

Problems associated with applying the equity DCF valuation method include

• determining the source of value, 
• the effect of leverage, and 
• the cost of holding equity capital.

Economic spread analysis can help determine the sources of value creation.

Other complications in bank valuations are

• monitoring the yield curve and forward rates, 
• estimating loan loss provisions, 
• approximating the bank's equity risk capital needs, and 
• constructing separate statements for each of the bank's activities.

Valuing Cyclical Companies

A cyclical company is one whose earnings demonstrate a repeating pattern of increases and decreases.

The earnings of such companies fluctuate because of large

• changes in the prices of their products or 
• changes in volume.

Volatile earnings introduce additional complexity into the valuation process, as historical performance must be assessed in the context of the cycle.


The share prices of companies with cyclical earnings tend to be more volatile than those of less cyclical companies.

However their discounted cash flow (DCF) valuations are much more stable.



Why are the share prices of cyclical companies more volatile?

Earnings forecasts may be the reason that the former is more volatile than the latter.

Analysts' projections of the profits of cyclical companies are not very accurate, in that they tend not to forecast the downturns and generally have positive biases.

Analysts may produce biased forecasts for these cyclical firms from fear of retaliation from the managers of the firms they analyse.

The behaviour of the managers may play a role in the cyclicality.

They tend to increase and decrease investments at the same time (i.e., exhibit herd behaviour).

Three explanations for this behaviour are:

• cash is generally more available when prices are high,
• it is easier to get approval from boards of directors for investments when profits are high, and 
• executives get concerned about the possibilities of rivals growing faster than their firms.

An approach for evaluating a cyclical firm

The following steps outline one approach for evaluating a cyclical firm:

• construct and value the normal cycle scenario using information about past cycles;
• construct and value a new trend line scenario based on the recent performance of the company;
• develop the economic rationale for each of the two scenarios, considering factors such as demand growth, companies entering or exiting the industry, and technology changes that will affect the balance of supply and demand; and 
• assign probabilities to the scenarios and calculate their weighted values.

Capital Structure, Dividends and Share Repurchases

There is usually more to lose than to gain when making a decision in this area.

Managers should manage capital structure with the goal of not destroying value as opposed to trying to create value.

There are three components of a company's financial decisions:

1. how much to invest,
2. how much debt to have, and 
3. how much cash to return to shareholders.

Choices concerning capital structure

Managers have many choices concerning capital structure, for example,

1. using equity,
2. straight debt,
3. convertibles and
4. off-balance-sheet financing.

Managers can create value from using tools other than equity and straight debt under only a few conditions.

Even when using more exotic forms of financing like convertibles and preferred stock, fundamentally it is a choice between debt and equity.




Debt and Equity Financial Choices trade-offs

Managers must recognise the many trade-offs to both the firm and investors when choosing between debt and equity financing.

The firm increases risk but saves on taxes by using debt; however, investing in debt rather than equity probably increases the tax liability to investors.

Debt has been shown to impose a discipline on managers and discourage over investment, but it can also lead to business erosion and bankruptcy.

Higher debt increases the conflicts among the stakeholders.




Credit rating is a useful indicator of capital structure health

Most companies choose a capital structure that gives them a credit rating between BBB- and A+, which indicates these are effective ratings and capital structure does not have a large effect on value in most cases.

The capital structure can make a difference for companies at the far end of the coverage spectrum.

Credit ratings

• are a useful summary indicator of capital structure health and 
• are a means of communicating information to shareholders.

The two main determinants of credit ratings are

• size and 
• interest coverage.

Two important coverage ratios are

• the EBITA to interest ratio and 
• the debt to EBITA ratio.

The former is a short-term measure, and the latter is more useful for long-term planning.




Methods to manage capital structure

Managers must weight the benefits of managing capital structure against

• the costs of the choices and 
• the possible signals the choices send to investors.

Methods to manage capital structure include

• changing the dividends, 
• issuing and buying back equity, and
• issuing and paying off debt

When designing a long-term capital structure, the firm should

• project surpluses and deficits, 
• develop a target capital structure, and 
• decide on tactical measures.  

The tactical, short-term tools include

• changing the dividend,
• repurchasing shares, and 
• paying an extraordinary dividend.

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.

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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.



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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.