David Wessels - Corporate Strategy and Valuation

2011 SIFMA Securities Industry Institute
Corporate Strategy and Valuation

An Assessment of Key Value Drivers
Professor David Wessels 2011 The Wharton School of the University of Pennsylvania p PA 19104 3620 Locust Walk, Philadelphia
How Growth G h Drives i Value l

In 1995, two Fortune 500 companies had $20 billion in revenue. Since then one company has grown dramatically dramatically. Which company is the high-growth company? A or B?
AggregateRevenues 19952010
80
CompanyA
MarketCapitalization($billions) Enterprise Value ($billions)
10.0%
146.6 158.4 18.1 1.5 21.0%
ForwardP/E(FYE'11) PEGRatio(3 yearexpected): ROIC(viaThomsonFirstCall):
60
$ billions
40
CompanyB
MarketCapitalization($billions)
4.4%
31.7 34.0 21.8 1.2 9.6%
Enterprise Value ($billions) ForwardP/E(FYE'11) PEGRatio(5yrexpected): ROIC(viaThomsonFirstCall):
20
0 1995 1998 2001 2004 2007 2010
Source:ThomsonFirstCall, Call Jan 11
Professor David Wessels The Wharton School of the University of Pennsylvania
27
Session Overview
A valuation model of two simple companies
Although profitability metrics such as EBITDA & Earnings Per Share (EPS) correlate with value, this is not always the case. Upfront investments must also be considered. considered
The key drivers of a companys value:

The e value va ue of o a company co pa y can ca be traced t aced to four ou key ey value va ue drivers, d ve s, co core e operating profit, return on capital, cost of capital (risk), and organic revenue growth. Every project projects s (or acquisitions) acquisition s) ROIC must properly compensate investors, otherwise value is destroyed and share price will fall.
A Model of Two Simple Companies

Company A plans to reinvest $50 million to grow the company. The financial staff projects a 10% rate of return on the new investment. This investment leads to an extra $5 million in profits. For simplicity, we assume all ratios, investment rate etc, never change.
CompanyA Reinvestmentrate ( (IR) ) Returnonnewinvestment Growthinprofits 50% 10% 5%
Year1 Aftertax operatingprofit NetInvestment Free cashflow 100.0 (50 0) (50.0) 50.0
Year2 105.0 (52 5) (52.5) 52.5
Year3 110.3 (55 1) (55.1) 55.1
Which Company is Worth More?

Company A and Company B currently earn $100 million in operating profit and expect profits to grow by 5%. 5% If both companies have 100 million common shares outstanding, what would each companys earnings per share (EPS) and EPS growth rate be?
CompanyA Reinvestmentrate (IR) Returnonnewinvestment Growthinprofits 50% 10% 5% CompanyB Reinvestmentrate (IR) Returnonnewinvestment Growthinprofits 25% 20% 5%
Year1 Aftertax operatingprofit NetInvestment Freecashflow 100.0 (50.0) 50.0
Year2 105.0 (52.5) 52.5
Year3 110.3 (55.1) 55.1 Aftertaxoperatingprofit NetInvestment Free cashflow
Year1 100.0 (25.0) 75.0
Year2 105.0 (26.3) 78.8
Year3 110.3 (27.6) 82.7
EPS G Growth: th O Only l P Part t of f th the St Story! !

Boston Scientific 3rd-quarter loss narrows Bill Berkrot, Reuters
Boston Scientific
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 g and a decline in sales of its drug-coated g stents. The company's adjusted profit of 18 cents per share topped Wall Street expectations by 2 cents, according to Reuters Estimates. 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, 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
Source: Yahoo! Finance
18
The Drivers of Profit Growth

Using the lessons learned from our two companies, we can create a general relation between g (growth), IR (reinvestment rate), and ROIC (return on invested capital).
Company A Reinvestment Rate (IR) Return on New Investment Growth in Profits 50% 10% 5%
Growth = Reinvestment * Rate of Return
G = IR * ROIC
Company A: Company B: 5% = 50% * 10% 5% = 25% * 20%
Company B Reinvestment Rate (IR) Return on New Investment Growth in Profits 25% 20% 5%
Th G The Growing i P Perpetuity t it Formula F l

A company is worth the present value of its future free cash flow. For example, Company A can be valued using:
Value = 50 52.5 55.1 + + + ......... (1.10) (1.10) (1 10) 2 (1.10) 3
In our simple example, cash flows grow forever at a constant rate. Therefore, we growth p perpetuity p y formula to value each company. p y can use the g
Value = Cash Flow 3 Cash Flow1 Cash Flow 2 + + + ......... (1 + WACC) ( ) ( (1 + WACC) )2 (1 ( + WACC) )3
Cashflow1 WACC g
via the growing perpetuity rormula
Value =
What Drives Value?
Cash Flow1 Value = WACC g

As Cash Flow rises, what happens to value? As WACC rises, what happens to value? A growth As th rises, i what h t happens h to t value? l ?
But what determines cash flow?
Deriving i i the h Key Value l Driver i Formula l

In order to develop the key value driver formula, we rely on two simple substitutions: the definition of cash flow and the growth, IR, and ROIC relation.
Cash Flow1 Value = WACC g
Profit(1 IR) WACC g
g Profit 1 ROIC WACC g
Substitution #1 Cash Flow = Profit (1 IR)
Substitution #2 Growth = IR x ROIC
10
The Key Value Driver Formula

Company p yA
g Profit 1 ROIC Value = WACC g

Company p yB
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
11
Growth vs. Value Indices

In 1992, Standard and Poor's and Barra (now MSCI) began a collaboration to produce Growth Growth and Value Value subsets of S&P S&P's s industry-leading equity indexes. indexes Through 2008, the sole criteria for the Growth/Value split was based on the market-tobook ratio for each firm.
Source: https://www.mscibarra.com/products/indices/us/performance.jsp
12
Whats in a Name Anyway?

Yet, what did growth Yet growth really mean? Were companies in the growth index growing? Based on evidence from an analysis of the indices by the corporate performance center at McKinsey and Company, the answer is no. Even though growth stocks slightly outgrow value stocks, the difference is not significantly significant! The two histograms look very similar, and growth outgrows value 10.1% to 8.7%.
S&P500Histogram 3YearAverageRevenueGrowth
14.0% 12.0%
Percent t ofSample
GrowthStocks
10.0% 8.0% 6 0% 6.0% 4.0% 2.0% 0 0% 0.0% 1.0% 5.0% 11.0% 17.0% 23.0%
Value Stocks
Source: McKinsey on Finance, Number 22, Fall 2007
13
Back to Return on Capital

In actuality, it is return on capital that distinguished the two indices.
Percen nt ofSample
S&P500Histogram 3YearAverageROIC (excludingGoodwill)

25.0% 20.0% 15.0% 10.0% 0 0% 5.0% 0.0% 5.0% 10.0% 25.0% 40.0%
For the value index, the median ROIC, averaged over three years, and excluding goodwill, is only 15 percent percent, compared with 35 percent for the growth index The correlation of M/Bs with ROIC in 2005 was 20 percent, percent versus 1 percent for growth rates.
Value Stocks GrowthStocks
Source: McKinsey on Finance, Number 22, Fall 2007
14
A Change in Composition
15
What Drives Value?

g Profit 1 ROIC Value = WACC g
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?
16
The Growth/Value Matrix

As we will show later, , if the spread p between ROIC and WACC is positive, new growth creates value. The market value of a company, with a starting Profit of $100 million, and d a 10% cost of f capital, i l is i as follows: f ll
ROIC 7.5% 2% Growth 4% 6% $917 778 500 10.0% 1,000 1,000 1,000 12.5% 1,050 1,133 1,300 15.0% 1,083 1,222 1,500
17
How Growth G h Drives i Value l

In 1995, two Fortune 500 companies had $20 billion in revenue. Since then one company has grown dramatically dramatically. Which company is the high-growth company? A or B?
AggregateRevenues 19952010
80
CompanyA
MarketCapitalization($billions) Enterprise Value ($billions)
10.0%
146.6 158.4 18.1 1.5 21.0%
ForwardP/E(FYE'11) PEGRatio(3 yearexpected): ROIC(viaThomsonFirstCall):
60
$ billions
40
CompanyB
MarketCapitalization($billions)
4.4%
31.7 34.0 21.8 1.2 9.6%
Enterprise Value ($billions) ForwardP/E(FYE'11) PEGRatio(5yrexpected): ROIC(viaThomsonFirstCall):
20
0 1995 1998 2001 2004 2007 2010
Source:ThomsonFirstCall, Call Jan 11
27
A th A Another Application: li ti Comparables/Multiples C bl /M lti l

A comparables table is a powerful tool to test the reasonableness of a companys valuation. l ti But B t most t tables t bl fail f il to t explicitly li itl tie ti market k t value l to t the th underlying value drivers.
Household&PersonalCare Enterprise Value ComparablesAnalysis OneYearForwardMultiples Market Ticker RB. CL PG CLX CHD KMB WDFC ENR
1
Net Debt (18.0) 3,866.0 39,333.0 3,324.0 407.6 7,738.0 (43 8) (43.8) 2,205.2
1
Enterprise Value 25,045.9 40,665.8 217,490.8 12,479.8 5,298.1 34,190.6 643 3 643.3 6,961.1 IndustryMean IndustryMedian StdDev/Mean Revenue 2.9 2.5 2.7 2.4 2.0 1.7 19 1.9 1.5 2.3 2.4 20.2% EBITDA 10.5 9.4 10.9 11.0 8.9 8.8 10 4 10.4 8.6 10.0 10.4 9.3% EBITA 11.1 10.2 12.5 13.0 9.9 11.0 10 8 10.8 10.0 11.2 11.0 10.1%
Company ReckittBenckiser Colgate Palmolive Procter&Gamble Clorox Church&Dwight KimberlyClark Wd40 EnergizerHoldings
Price 34.53 76.24 63.61 65.66 68.75 65.01 40 26 40.26 67.38
Cap 25,063.9 36,799.8 178,157.8 9,155.8 4,890.4 26,452.6 687 1 687.1 4,755.9
Debtanddebtequivalents,netofcash
19
Valuation l i Across A the h Industry d

A companys valuation should never be computed in isolation. Always triangulate results by comparing the valuation with other companies in the industry. Multiples should rise as your proceed to the top-right corner. Unexpected p revenue multiples should be investigated further.
Household&PersonalCare
RevenueMultiples
8% 7%
Projected5Ye ar Revenue Growth h
RB.,2.9x
6% 5% 4% 3% 2% 1% 0% 15% 17% 19% 21% 23% 25% 27% 29% CLX,2.4x KMB,1.7x CHD,2.0x PG,2.7x
CL,2.5x
ProjectedEBITA Margin
20
Appendix An Economic Profit Analysis
21
An Alternative Interpretation
Action Start with the key value driver formula.
g Profit 1 ROIC Value = WACC g g Capital ROIC 1 ROIC Value = WACC g
From the definition of ROIC ROIC, Profit equals invested capital times ROIC.
Move ROIC inside the brackets.
Value = Capital
ROIC g WACC g
22
An Alternative Intepretation
Action Add and Subtract WACC in the numerator.
Value = Capital
ROIC WACC + WACC g WACC g
Separate p the numerator
(ROIC WACC) Value = Capital + 1 WACC g
Distribute invested capital and were done!
(ROIC WACC) Value = Capital + Capital WACC g
23
Discounted EVA Formula

In order to determine what happens when growth changes, changes the formula must be rewritten, where InvCap equals invested capital.
(ROIC WACC) Value = Capital + Capital WACC g

EVA TM Value = Capital + WACC g
Now, as growth rises, what happens to value?
24
The Dilemma of Strong Performance

Enterprise value is comprised of the companys book value plus the present value of economic profits going forward. Based on the economic profit formula, what should a companys enterprise value equal if the company was expected to earn an ROIC equal to the cost of capital going forward?
Enterprise Value
8 348 8,348 6,059 12,047.0
Clorox EnterpriseValueDecomposition 2010
2,289
PV(Future Growth)
PV(Current Performance) Nonoperating assets Invested Capital
95 3,604
95 3,604
25
Analyzing Enterprise Value Over Time

To test the richness richness of a stock stock, we can decompose enterprise value into invested capital, the present value of current performance, and the present value of future growth. When the present value of future growth is high, management has strong expectations to meet. This analysis is similar to analyzing EV/EBITDA multiples.
Clorox
ENterprise Value Decomposition
16,000 14 000 14,000 12,000
PV(Future Growth)
USDmillions
10,000 8,000 6,000 4,000 2,000 0
PV(Current Performance) Nonoperating assets Invested Capital

2001 2003 2005 2007 2009 Jan2011
26

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2011 SIFMA Securities Industry Institute

Corporate Strategy and Valuation

Corporate Strategy and Valuation

2011 SIFMA Securities Industry Institute

Corporate Strategy and Valuation

How Growth G h Drives i Value l

146.6 158.4 18.1 1.5 21.0%

ForwardP/E(FYE'11) PEGRatio(3 yearexpected): ROIC(viaThomsonFirstCall):

31.7 34.0 21.8 1.2 9.6%

Enterprise Value ($billions) ForwardP/E(FYE'11) PEGRatio(5yrexpected): ROIC(viaThomsonFirstCall):

0 1995 1998 2001 2004 2007 2010

Source:ThomsonFirstCall, Call Jan 11

Professor David Wessels The Wharton School of the University of Pennsylvania

2011 SIFMA Securities Industry Institute

Corporate Strategy and Valuation

The key drivers of a companys value:

Professor David Wessels The Wharton School of the University of Pennsylvania

2011 SIFMA Securities Industry Institute

Corporate Strategy and Valuation

A Model of Two Simple Companies

Year2 105.0 (52 5) (52.5) 52.5

Year3 110.3 (55 1) (55.1) 55.1

Professor David Wessels The Wharton School of the University of Pennsylvania

2011 SIFMA Securities Industry Institute

Corporate Strategy and Valuation

Which Company is Worth More?

Year1 Aftertax operatingprofit NetInvestment Freecashflow 100.0 (50.0) 50.0

Year2 105.0 (52.5) 52.5

Year3 110.3 (55.1) 55.1 Aftertaxoperatingprofit NetInvestment Free cashflow

Year1 100.0 (25.0) 75.0

Year2 105.0 (26.3) 78.8

Year3 110.3 (27.6) 82.7

Professor David Wessels The Wharton School of the University of Pennsylvania

2011 SIFMA Securities Industry Institute

Corporate Strategy and Valuation

EPS G Growth: th O Only l P Part t of f th the St Story! !

Source: Yahoo! Finance

Professor David Wessels The Wharton School of the University of Pennsylvania

2011 SIFMA Securities Industry Institute

Corporate Strategy and Valuation

The Drivers of Profit Growth

Growth = Reinvestment * Rate of Return

Professor David Wessels The Wharton School of the University of Pennsylvania

2011 SIFMA Securities Industry Institute

Corporate Strategy and Valuation

Th G The Growing i P Perpetuity t it Formula F l

Professor David Wessels The Wharton School of the University of Pennsylvania

2011 SIFMA Securities Industry Institute

Corporate Strategy and Valuation

What Drives Value?

Cash Flow1 Value = WACC g

But what determines cash flow?

Professor David Wessels The Wharton School of the University of Pennsylvania

2011 SIFMA Securities Industry Institute

Corporate Strategy and Valuation

Deriving i i the h Key Value l Driver i Formula l

Cash Flow1 Value = WACC g

Profit(1 IR) WACC g

g Profit 1 ROIC WACC g

Substitution #1 Cash Flow = Profit (1 IR)