David Wessels - Corporate Strategy and Valuation

2011 SIFMA Securities Industry InstituteCorporate Strategy and Valuation 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 2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation How Growth G h Drives i Value l • In 1995, two Fortune 500 companies had $20 billion in revenue. Since then one company has grown dramatically dramatically. Which company is the high-growth company? A or B? Aggregate Revenues  1995‐2010 80   Company A Market Capitalization ($ billions) Enterprise  Value  ($ billions) 10.0% 146.6 158.4 18.1 1.5 21.0% Forward P/E (FYE '11) PEG Ratio (3‐ year expected): ROIC (via Thomson First Call): 60   $  billions 40   Company B Market Capitalization ($ billions) 4.4% 31.7 34.0 21.8 1.2 9.6% Enterprise  Value  ($ billions) Forward P/E (FYE '11) PEG Ratio (5 yr expected): ROIC (via Thomson First Call): 20   0  1995 1998 2001 2004 2007 2010 Source: Thomson First Call, Call  Jan‐ 11 Professor David Wessels The Wharton School of the University of Pennsylvania 27 otherwise value is destroyed and share price will fall. – Every project project’s s (or acquisition’s) acquisition s) ROIC must properly compensate investors. co core e operating profit. Upfront investments must also be considered. cost of capital (risk). Professor David Wessels The Wharton School of the University of Pennsylvania 3 . return on capital. considered • The key drivers of a company’s 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. and organic revenue growth.2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation Session Overview • A valuation model of two simple companies – Although profitability metrics such as EBITDA & Earnings Per Share (EPS) correlate with value. d ve s. this is not always the case. we assume all ratios. This investment leads to an extra $5 million in profits. investment rate etc.3 (55 1) (55. For simplicity.0 (50 0) (50.0 (52 5) (52. never change. Company A Reinvestment rate  ( (IR) ) Return on new investment Growth in profits 50% 10% 5% • • Year 1 After‐tax  operating profit Net Investment Free  cash flow 100.5 Year 3 110.0) 50.5) 52. The financial staff projects a 10% rate of return on the new investment.2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation A Model of Two Simple Companies • Company A plans to reinvest $50 million to grow the company.1) 55.1 Professor David Wessels The Wharton School of the University of Pennsylvania 4 .0 Year 2 105. 3 (55.0 (50.0 (52.5) 52.3 (27.1) 55.3) 78.5 Year 3 110.0) 75.0 Year 2 105. what would each company’s earnings per share (EPS) and EPS growth rate be? Company A Reinvestment rate  (IR) Return on new investment Growth in profits 50% 10% 5% Company B Reinvestment rate  (IR) Return on new investment Growth in profits 25% 20% 5% Year 1 After‐tax  operating profit Net Investment Free cash flow 100. 5% If both companies have 100 million common shares outstanding.6) 82.8 Year 3 110.7 Professor David Wessels The Wharton School of the University of Pennsylvania 5 .0) 50.0 (26.2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation Which Company is Worth More? • • Company A and Company B currently earn $100 million in operating profit and expect profits to grow by 5%.0 (25.1 After‐tax operating profit Net Investment Free  cash flow Year 1 100.0 Year 2 105. 98 billion from $2. The company's adjusted profit of 18 cents per share topped Wall Street expectations by 2 cents." said Phillip Nalbone.05 billion. "It was kind of an on-target quarter and right now with Boston Scientific. but that was in line with Wall Street expectations. an analyst with RBC Capital Markets. Estimates Total net sales for the quarter fell to $1.2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation EPS G Growth: th O Only l P Part t of f th the St Story! ! Boston Scientific 3rd-quarter loss narrows Bill Berkrot.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. Oct 21 (Reuters) . Reuters Boston Scientific NEW YORK. Scientific not falling below the range of expectations is a good thing. Source: Wall Street Journal Source: Yahoo! Finance Professor David Wessels The Wharton School of the University of Pennsylvania 18 . according to Reuters Estimates. IR (reinvestment rate).2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation The Drivers of Profit Growth • Using the lessons learned from our two companies. we can create a general relation between g (growth). 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% Professor David Wessels The Wharton School of the University of Pennsylvania 7 . .10) 3 • In our simple example...10) (1. we growth p perpetuity p y formula to value each company. (1 + WACC) ( ) ( (1 + WACC) )2 (1 ( + WACC) )3 Cashflow1 WACC − g via the growing perpetuity rormula Value = Professor David Wessels The Wharton School of the University of Pennsylvania 8 .1 + + + ... p y can use the g Value = Cash Flow 3 Cash Flow1 Cash Flow 2 + + + ...5 55..2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation 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.... Company A can be valued using: Value = 50 52. cash flows grow forever at a constant rate. Therefore. (1. For example.10) (1 10) 2 (1...... what happens to value? As WACC rises. what happens to value? A growth As th rises.2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation What Drives Value? Cash Flow1 Value = WACC − g As Cash Flow rises. i what h t happens h to t value? l ? But what determines cash flow? Professor David Wessels The Wharton School of the University of Pennsylvania 9 . 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 Professor David Wessels The Wharton School of the University of Pennsylvania 10 . and ROIC relation.2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation 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. 2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation 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 .Weighted Average Cost of Capital (Hurdle Rate) g – Long term growth in profit and cash flows Professor David Wessels The Wharton School of the University of Pennsylvania 11 .Return on Invested Capital (ROI/RONIC/ROCE/RONA) WACC . jsp Professor David Wessels The Wharton School of the University of Pennsylvania 12 . the sole criteria for the Growth/Value split was based on the market-tobook ratio for each firm. 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.mscibarra. indexes Through 2008. Source: https://www.com/products/indices/us/performance.2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation “Growth” vs. “Value” Indices • • In 1992. 0% 6 0% 6. 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.7%.0% 11.0% 17.0% Percent t  of Sample • Growth Stocks 10. S&P 500 Histogram  3‐Year Average Revenue Growth 14. Even though “growth” stocks slightly outgrow “value” stocks. the difference is not significantly significant! The two histograms look very similar. the answer is no.0% 8.0% • Value  Stocks Source: McKinsey on Finance.0% 5.0% ‐1.1% to 8.0% 0 0% 0.0% 2.0% 23.0% 12. Fall 2007 Professor David Wessels The Wharton School of the University of Pennsylvania 13 .0% 4. Number 22. and “growth” outgrows “value” 10.2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation What’s in a Name Anyway? • Yet. 0% ‐5. the median ROIC. is only 15 percent percent. Fall 2007 Professor David Wessels The Wharton School of the University of Pennsylvania 14 .0% 0. averaged over three years. Value  Stocks Growth Stocks • Source: McKinsey on Finance. compared with 35 percent for the growth index The correlation of M/Bs with ROIC in 2005 was 20 percent. and excluding goodwill.0% 40.0% 10. Percen nt  of Sample S&P 500 Histogram  3‐Year Average ROIC  (excluding Goodwill) 25.0% 10.0% 25.0% 15.0% 0 0% 5.2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation Back to Return on Capital… • In actuality. Number 22. percent versus 1 percent for growth rates.0% 20.0% • For the value index. it is return on capital that distinguished the two indices. 2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation A Change in Composition Professor David Wessels The Wharton School of the University of Pennsylvania 15 . what happens to value? As ROIC rises. what happens to value? As growth rises. what happens to value? Professor David Wessels The Wharton School of the University of Pennsylvania 16 .2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation What Drives Value? g ⎞ ⎛ Profit ⎜1 − ⎟ ROIC ⎠ ⎝ Value = WACC − g As starting Profit rises. what happens to value? As WACC rises. 0% 1. with a starting Profit of $100 million. new growth creates value.5% 1.300 15. if the spread p between ROIC and WACC is positive. and d a 10% cost of f capital.000 12.222 1.000 1.2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation The Growth/Value Matrix • • As we will show later.5% 2% Growth 4% 6% $917 778 500 10.500 Professor David Wessels The Wharton School of the University of Pennsylvania 17 .083 1.050 1. i l is i as follows: f ll ROIC 7. .000 1. The market value of a company.0% 1.133 1. 8 1.0 21. Which company is the high-growth company? A or B? Aggregate Revenues  1995‐2010 80   Company A Market Capitalization ($ billions) Enterprise  Value  ($ billions) 10. Since then one company has grown dramatically dramatically.4% 31. two Fortune 500 companies had $20 billion in revenue.1 1.4 18.2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation How Growth G h Drives i Value l • In 1995.0% 146.5 21.6 158. Call  Jan‐ 11 Professor David Wessels The Wharton School of the University of Pennsylvania 27 .6% Enterprise  Value  ($ billions) Forward P/E (FYE '11) PEG Ratio (5 yr expected): ROIC (via Thomson First Call): 20   0  1995 1998 2001 2004 2007 2010 Source: Thomson First Call.7 34.0% Forward P/E (FYE '11) PEG Ratio (3‐ year expected): ROIC (via Thomson First Call): 60   $  billions 40   Company B Market Capitalization ($ billions) 4.2 9. 3 2.8 10.9  Debt and debt equivalents.866.0 9.0 10.3 6.8 5.6 7. 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 & Personal Care Enterprise  Value  Comparables Analysis One‐Year Forward Multiples Market Ticker RB.7 2.0 10.0 8.1 Industry Mean Industry Median Std Dev /Mean Revenue 2.4 26.4 10.9 1.9 11.7 19 1.01 40 26 40.452.38 Cap 25.8 12.0) 3.2 1 Enterprise Value 25.0 39.0 1.1 34.2% EBITDA 10.5 2.9 40.53 76.5 13.333.6 10.890.490.5 2.298.8 178.1 4.8 9.205.75 65.190.66 68. CL PG CLX CHD KMB WDFC ENR 1 Net Debt (18.9 2.26 67.045.8 217.0 407. net of cash Professor David Wessels The Wharton School of the University of Pennsylvania 19 .157.9 11.961.8 4.9 36.0 (43 8) (43.4 20.61 65.755.3% EBITA 11.9 8.6 687 1 687.479.155.24 63.0 10 8 10.5 9.4 2.4 9.0 11.1 10.665.2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation 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 company’s ’ valuation.1% Company Reckitt Benckiser  Colgate ‐Palmolive Procter & Gamble Clorox Church & Dwight Kimberly‐Clark Wd‐40 Energizer Holdings Price 34.6 643 3 643.8) 2.799.324.8 10 4 10.738.063.0 3.2 11.4 8.2 12. 0x PG. Always triangulate results by comparing the valuation with other companies in the industry..2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation Valuation l i Across A the h Industry d • A company’s valuation should never be computed in isolation.9x 6% 5% 4% 3% 2% 1% 0% 15% 17% 19% 21% 23% 25% 27% 29% CLX. 2. 2. 1.7x CHD. 2.7x CL. 2. Household & Personal Care Revenue Multiples  8% 7% Projected 5‐Ye ar  Revenue  Growth h RB.4x KMB. Multiples should rise as your proceed to the top-right corner. 2.5x • Projected EBITA  Margin 20 . Unexpected p revenue multiples should be investigated further. 2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation Appendix An Economic Profit Analysis 21 . • Move ROIC inside the brackets. g ⎞ ⎛ Profit ⎜1 − ⎟ ROIC ⎝ ⎠ Value = WACC − g g ⎞ ⎛ Capital × ROIC × ⎜1 − ⎟ ROIC ⎠ ⎝ Value = WACC − g • From the definition of ROIC ROIC.2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation An Alternative Interpretation Action • Start with the key value driver formula. Value = Capital ROIC − g WACC − g 22 . Profit equals invested capital times ROIC. 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 .2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation An Alternative Intepretation Action • Add and Subtract WACC in the numerator. as growth rises. ⎡ (ROIC − WACC) ⎤ Value = Capital + Capital⎢ ⎥ WACC g − ⎣ ⎦ EVA TM Value = Capital + WACC − g • Now. changes the formula must be rewritten. what happens to value? 24 . where InvCap equals invested capital.2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation Discounted EVA™ Formula • In order to determine what happens when growth changes. 289 PV(Future Growth) • PV(Current Performance) Nonoperating assets Invested Capital 95 3.0  Clorox Enterprise Value Decomposition 2010 2.047.059 12.2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation The Dilemma of Strong Performance • Enterprise value is comprised of the company’s book value plus the present value of economic profits going forward. what should a company’s enterprise value equal if the company was expected to earn an ROIC equal to the cost of capital going forward? Enterprise Value 8 348 8.604 95 3. Based on the economic profit formula.348 6.604 25 . When the present value of future growth is high. Clorox ENterprise  Value  Decomposition 16. This analysis is similar to analyzing EV/EBITDA multiples. the present value of current performance. and the present value of future growth.000   6.2011 SIFMA Securities Industry Institute Corporate Strategy and Valuation Analyzing Enterprise Value Over Time • To test the “richness” richness of a stock stock.000  14 000  14. we can decompose enterprise value into invested capital.000  8.000   0  PV(Current Performance) Nonoperating assets Invested Capital 2001 2003 2005 2007 2009 Jan‐2011 • • 26 . management has strong expectations to meet.000   2.000   4.000  PV(Future Growth) USD millions 10.000 12.