VALUE THE FOUR CORNERSTONES OF CORPORATE FINANCE MCKINSEY & COMPANY TIM KOLLER RICHARD DOBBS BILL HUYETT

Transcription

1 VALUE THE FOUR CORNERSTONES OF CORPORATE FINANCE MCKINSEY & COMPANY TIM KOLLER RICHARD DOBBS BILL HUYETT

2 Exhibit 1.1: Correlation Between Total Returns to Shareholders (TRS) and Employment Growth 2

3 Exhibit 1.2: Correlation Between TRS and R&D Expenditures 3

4 Exhibit 2.1: Growth and ROIC Drive Value Exhibit 2.2: Tale of Two Companies: Same Earnings, Different Cash Flows 4

5 Exhibit 2.3: Value Inc.: Discounted Cash Flow Valuation Exhibit 2.4: Payout Ratio Varies with Growth and ROIC 5

6 Exhibit 2.5: Translating Growth and ROIC Into Value 6

7 Exhibit 2.6: Estimating Fundamental Market Valuation Levels 7

8 Exhibit 2.7: Consumer Staples Sector: Growth and ROIC Drive P/E Multiples Exhibit 2.8: Increasing Value: Impact of Higher Growth and ROIC 8

9 Exhibit 2.9: Value Creation by Type of Growth: Consumer Products Company 9

10 Exhibit 3.1: How Johnson & Johnson Turbocharged Neutrogena s Growth 10

11 Exhibit 3.2: Cash Flows Related to Collateralized Debt Obligations 11

12 Exhibit 4.1: Wal-Mart vs. Target: Wal-Mart Ahead on Growth, ROIC, Not TRS 12

13 Exhibit 4.2: Wal-Mart vs. Target: P/E Increase Helps Target s TRS Exhibit 4.3: Wal-Mart vs. Target: TRS Decomposition 13

14 Exhibit 6.1: Model of the Stock Market 14

15 Exhibit 6.2: Investors Segmented by Investment Strategies Exhibit 6.3: Intrinsic Investors Have Greatest Impact on Share Price 15

16 Exhibit 7.1: Inflation-Adjusted S&P 500 Price Index 16

17 Exhibit 7.2: U.S. Equity Market: Five Eras 17

18 Exhibit 7.3: Fundamentals Drive Stock Performance over Five Eras 18

19 Exhibit 7.4: Modeling the Stock Market 19

20 Exhibit 7.5: Projections Tend to Anchor on Recent History 20

21 Exhibit 7.6: Modeled P/E Closely Tracks Actual Market 21

22 Exhibit 7.7: Anchored Model Performs Better Than the Trend Model 22

23 Exhibit 8.1: Estimating Fundamental Market Valuation Levels Exhibit 8.2: Impact of Largest Stocks on Overall Market Valuation 23

24 Exhibit 8.3: Stock Market Bubbles: China and Saudi Arabia 24

25 Exhibit 9.1: Short-Term CFO Actions to Hit Earnings Target 25

26 Exhibit 9.2: Aggregate EPS Forecast for S&P 500 Index 26

27 Exhibit 9.3: Long-Term Earnings Growth: Forecasted vs. Actual 27

28 Exhibit 9.4: Long-Term Performance Expectations Drive Share Price 28

29 Exhibit 9.5: Earnings Volatility and TRS Not Linked 29

30 Exhibit 9.6: Earnings Growth of Least Volatile Companies: 1 Not So Smooth 30

31 Exhibit 10.1: ROIC Variations Across and Within Industries 31

32 Exhibit 10.2: Persistence of Industry ROICs 32

33 Exhibit 10.3: ROIC Transition Probability, Exhibit 10.4: U.S.-Based Nonfinancial Companies: ROIC,

34 Exhibit 10.5: Distribution of ROIC: Shifting to the Right 34

35 Exhibit 10.6: ROIC Trends Across Industries 35

36 Exhibit 10.7: ROIC with Goodwill Is Flat 36

37 Exhibit 11.1: Value of Different Types of Growth 37

38 Exhibit 11.2: Distribution of Growth Rates 38

39 Exhibit 11.3: Long-Term Revenue Growth for Nonfinancial Companies Exhibit 11.4: Revenue Growth Transition Probability 39

40 Exhibit 11.5: Variation in Growth over Product Life Cycle 40

41 Exhibit 11.6: Wal-Mart and ebay: Growth Trajectories Exhibit 11.7: The Challenge of Sustaining High Growth 41

42 Exhibit 11.8: Considerable Variation in Revenue Growth 42

43 Exhibit 13.1: Acquisition Evaluation Framework 43

44 Exhibit 13.2: Value Creation for Given Performance Improvements and Premium Paid Exhibit 13.3: Selected Acquisitions: Significant Improvements 44

45 Exhibit 13.4: EPS Accretion with Value Destruction Exhibit 13.5: Market Reaction to EPS Impact of Acquisitions 45

46 Exhibit 14.1: Volatility of Portfolio Return: Declining with Diversification Exhibit 14.2: Example of Risk Measurement 46

47 Exhibit 14.3: Analysis of Project A Exhibit 14.4: Impact of Nuclear Plant on Company Value 47

48 Exhibit 15.1: Effect of Leverage on Returns Exhibit 15.2: Tax Benefit of Debt: Limited Impact on Enterprise Value 48

49 Exhibit 16.1: Chemco: Valuation in Line with Close Peers 49

50 Exhibit 16.2: Whole Foods: ROIC by Age of Store Exhibit 16.3: Lowe s: Customer Transactions and Average Ticket Size 50

51 Exhibit 16.4: Minimal Impact of Guidance on TRS 51

52 Exhibit 17.1: Performance and Health Metrics 52

53 Appendix A: The Math of Value For the mathematically inclined, this appendix shows the core-of-value cornerstone as a simple formula along with its derivation. We call this the key value driver formula as it relates the value of a company to growth and ROIC: Where: Net operating profit less adjusted taxes (NOPLAT) represents the profits generated from the company s core operations after subtracting corresponding income taxes. Return on invested capital (ROIC) is the return the company earns on each dollar invested in the business: Invested capital represents the cumulative amount the business has invested in its core operations primarily property, plant and equipment, and working capital. Weighted average cost of capital (WACC) is the rate of return that investors expect to earn from investing in the company and, therefore, the appropriate discount rate for the free cash flow. Growth (g) is the rate at which the company s NOPLAT and cash flow grow each year. To derive the core value driver formula, we also need to define the following variables: Net investment is the increase in invested capital from one year to the next: Net Investment = Invested Capital t+1 Invested Capital t Free cash flow (FCF) is the cash flow generated by the core operations of the business after deducting investments in new capital: FCF = NOPLAT Net Investment 53

54 Investment rate (IR) is the portion of NOPLAT invested back into the business: Assume that the company s revenues and NOPLAT grow at a constant rate, and the company invests the same proportion of its NOPLAT in its business each year. Investing the same proportion of NOPLAT each year also means that the company s free cash flow will grow at the same rate as NOPLAT. Because the company s cash flows are growing at a constant rate, we can begin by valuing a company using the well-known cash flow perpetuity formula: This formula is well established in the finance and mathematics literature. * Next, define free cash flow in terms of NOPLAT and the investment rate: In Chapter 2, we developed the relationship between the investment rate (IR), the company s projected growth in NOPLAT (g), and the return on investment (ROIC): Solving for IR, rather than g, leads to g = ROIC IR Now build this into the definition of free cash flow: * For the derivation see T. E. Copeland and J. Fred Weston, Financial Theory and Corporate Policy, 3rd ed. (Reading, MA: Addison Wesley, 1988), Appendix A. Technically, we should use the return on new or incremental capital, but for simplicity here, we assume that the ROIC and incremental ROIC are equal. 54

55 Substituting for free cash flow gives the key value driver formula: Migrating the forecast assumptions for Value Inc. and Volume Inc. (from Exhibit 2.3) into the key value driver formula results in the same values we came up with when we discounted their cash flows: We call the key value driver formula the Tao of corporate finance because it relates a company s value to the fundamental drivers of economic value: growth, ROIC, and the cost of capital. You might go so far as to say that this formula represents all there is to valuation. Everything else is mere detail. However, we usually don t use this formula in practice. In most situations, the model is overly restrictive, as it assumes a constant ROIC and growth rate going forward. For companies whose key value drivers are expected to change, we need a model that is more flexible. Nevertheless, the formula is very useful in helping to keep the mind focused on what drives value. We can also use the key value driver formula to show that ROIC and growth determine earnings multiples, such as price-to-earnings and market-to-book ratios. To see this, divide both sides of the key value driver formula by NOPLAT: As the formula shows, a company s earnings multiple is driven by both its expected growth and its return on invested capital. 55

56 You can also turn the formula into a value-to-invested-capital formula. Start with the identity: NOPLAT = Invested Capital ROIC Substitute this definition of NOPLAT into the key value driver formula: Divide both sides by invested capital: 56

57 Exhibit B.1: Forward Enterprise Multiples Have Less Dispersion Than Traditional P/E Multiples 57

58 Exhibit B.2: Multiple Comparisons Require Right Peer Group 58