More Corrections and Perpetual Growth Valuation

More Corrections and Perpetual Growth Valuation Valuation and Financial Statement Analysis Peking University Guanghua School of Management April 1, 2019

Lecture 2 Pre-Reading Read McKinsey Valuation pg 161-163. Review pages 139-152 Read Henkel Annual Report for 2016. Don t read the whole thing. Just look at the financials and the products. Know what they are sell. www.jeffreytowson.com 1

Review of Operating Assets, Asset Valuation & EPV Perpetual Growth Exercise Corrections and Perpetual Growth Discount Rate vs. Cost of Capital (If Not in Lecture 1) Break - 15 min Operating Assets and Operating Liabilities Valuation Case Henkel DCF Cash Flow Scenarios Part 1 www.jeffreytowson.com 2

Separate Out the Operating Engine THE OPERATING ENGINE Operating Assets and Operating Liabilities Net Operating Cash Flow After Taxes Remove interest (and its tax shield) Remove taxes on non-operating income Financial Assets and Stuff Excess cash and marketable securities Cross-holdings Financial assets Unused operating assets Excess pension funding Contingent liabilities (lawsuits) Underfunded pensions? Other? Equity and equity equivalents Page 3 Debt and debt equivalents Interest bearing liabilities Leases? View them as loans 3

Common Valuation Calculations Asset Value (AV) Mostly about balance sheet. You value a business by valuing its individual assets. Assets can be tangible or intangible. Intangible are becoming more important. 1. Liquidation Value: Selling its assets piece meal, rather than as a composite business, you estimate what you will get from each asset or asset class individually. Fire Sale? Break-up value? Net-Nets? 2. Reproduction Value 3. Book accounting value 4. Sum of the parts: If a business is made up of individual divisions or assets, you may want to value these parts individually for one of two groups: Potential acquirers may want to do this, as a precursor to restructuring the business. Investors may be interested because a business that is selling for less than the sum of its parts may be cheap. 4

Common Valuation Calculations (cont) 5. Earnings Power Value (EPV) About current and recent earnings Good for reversion to mean Changes in balance sheet over time 6. Discounted Cash Flow (DCF) Value a business based upon the cash flows you expect that business to generate over time. Value of growth? Discount rate? Relative Valuation / Comparables: You value a business based upon how similar businesses are priced. Really just a market price. 5

Earnings Power Value (EPV) EPV makes assumptions about the sustainability of current earnings and the cost of capital but not future growth. EPV = Adjusted Earnings / Cost of Capital. This is based on current earnings What time frame? One year? Whole business cycle? Adjusted to reflect baseline performance for sustainable levels of distributable cash. Remove one-time charges Earnings are constant Keep assets same at end of period as at starting No growth EPV = Baseline Earnings * (1/WACC) Earnings x 10 www.jeffreytowson.com 6

Earnings Power Value (EPV) Typical Approach www.jeffreytowson.com 7

Earnings Power Value (EPV) www.jeffreytowson.com 8

Earnings Power Value (EPV) www.jeffreytowson.com 9

Where is EPV? Intrinsic Value (Economic Value per Share) EPV Time www.jeffreytowson.com 10

How Do These Relate? Intrinsic Value (Economic Value per Share) RV LV EPV?? Time www.jeffreytowson.com 11

Revenue Operating Results Year 0 Year 1 Steady-State Corrections -1x charges -Key person -Cyclical -Op leases -Exclude nonoperating -Cap R&D Operating Engine Valuation Growth Assumption - EPV (0)? - Perpetual? - Stages? Cash Outflows Gross Cash Flow = EBIT(1-tax) Non-Operating & Financial Assets Excess Cash Investments Unused op assets Excess pension Cost of Rev Gross Profit Op Expenses Depreciation EBIT Cash Inflows Net Increases in Invested Capital - Increases in WC - Increases Tangible Assets - Increases Intangible Assets Owners Earnings FCF (Net Cash Flow) Discount Rate? Interest-Bearing Debt Interest Expense Amort Operating Working Capital Operating Tangible Assets Operating Intangible Assets Year 0 Year 1 Steady-State Operating Assets and Operating Liabilities Year 0 Year 1 Steady-State Ownership of Debt & Debt Equivalents - Coverage Year 0 Year 1 Steady-State Taxes (on Op income) EBIT(1-tax) Capex Mainten Capex Growth

Source: McKinsey & Co Valuation book Page 13 13

Source: McKinsey & Co Valuation book Page 14 14

Source: McKinsey & Co Valuation book Page 15 15

Source: McKinsey & Co Valuation book Page 16 16

Review of Operating Assets, Asset Valuation & EPV Perpetual Growth Exercise Corrections and Perpetual Growth Discount Rate vs. Cost of Capital (If Not in Lecture 1) Break - 15 min Operating Assets and Operating Liabilities Valuation Case Henkel The Forest For the Trees. A Pre-DCF Rant. DCF www.jeffreytowson.com 17

But What About The Future? Time Intrinsic Value (Economic Value per Share) EPV? www.jeffreytowson.com 18

"A girl in a convertible is worth five in the phonebook. Warren Buffett Page 19 19

"A bird in the hand is worth two in the bush. 6 th Century BC? Page 20 20

How would you teach valuation? - Me It s all about figuring out how many birds are in the bush and when then are going to appear. Warren Buffett Page 21 21

2 Growth, ROIC and Value Are Inter-Related Source: McKinsey & Co Valuation book

2 How Much Value Created Depends on the Type of Revenue Growth Source: McKinsey & Co Valuation book

2 Do You Want to Increase Growth or ROIC? Source: McKinsey & Co Valuation book

2 Growth vs. ROIC Is Important Source: McKinsey & Co Valuation book

2 Growth vs. ROIC Is Important (Continued) Source: McKinsey & Co Valuation book

A Simple Approach is Perpetual Growth Time Intrinsic Value (Economic Value per Share) EPV Perpetual Growth DCF? www.jeffreytowson.com 29

3 Perpetual Growth With Fixed Reinvestment Is Important - But a Little Complicated. EPV was about zero growth and the operating assets being maintained but not increased. Growth usually requires adding to the operating assets. This means reinvestment and the return on that investment. So a simple definition is: Expected growth rate = Reinvestment rate * Return on capital If we assume a 2% growth rate in perpetuity and a 20% return on capital. RIR = g / ROC = 2% / 20% = 10% Reinvestment rate (RIR) = Changes in net working capital + (capex depreciation)

How Do These Approaches Relate? www.jeffreytowson.com 31

Growth Can Be Good or Bad for Value Growth only adds value to franchises and strong competitive advantages. EPV is greater than AV Frequently over-valued If EPV = AV Growth adds no value If EPV<AV Growth adds no value Bad management Or excess capacity www.jeffreytowson.com 32

www.jeffreytowson.com 33

Review of Operating Assets, Asset Valuation & EPV Perpetual Growth Exercise Corrections and Perpetual Growth Discount Rate vs. Cost of Capital (If Not in Lecture 1) Break - 15 min Operating Assets and Operating Liabilities Valuation Case Henkel The Forest For the Trees. A Pre-DCF Rant. DCF www.jeffreytowson.com 34

Sofa Valuation 1: Coffee Bar There is a coffee bar for sale by the owner, who is also the manager. You have access to the financial statements for the last 3 years. In the most recent year, the business reported: $1.2 million in revenues $400,000 in pre-tax operating profit No conventional debt outstanding, but it has a lease commitment of $120,000 each year for the next 12 years. Adapted from exercise by A Damodaran 3

Past Income Statements 3 years ago 2 years ago Last year Revenues $800 $1,100 $1,200 Operating at full capacity - Operating lease expense $120 $120 $120 (12 years left on the lease) - Wages $180 $200 $200 (Owner/manager does not draw salary) - Material $200 $275 $300 (25% of revenues) - Other operating expenses $120 $165 $180 (15% of revenues) Operating income $180 $340 $400 - Taxes $72 $136 $160 (40% tax rate) Net Income $108 $204 $240 All numbers are in thousands Adapted from exercise by A Damodaran 3

3 Correction: Assess the Impact of the Key Person. If 20% of the patrons are drawn to the coffee shop because of the manager, the expected operating income will be lower if leaves. Adjusted operating income (existing mgr) = $ 370,000 Operating income (adjusted for mgr departure) = $296,000 As the new owner, what might you be able to do to mitigate this loss in value?

Adjust the Financial Statements to Give a Steady-State Operating Picture Stated Adjusted Revenues $1,200 $1,200 - Operating lease expenses $120 Leases converted to financial expenses - Wages $200 $350 Hire a manager for $150,000/year - Material $300 $300 - Other operating expenses $180 $180 Operating income $400 $370 - Interest expenses $0 $69.62 7.5% of $928.23 (see below) Taxable income $400 $300.38 - Taxes $160 $120.15 Net Income $240 $180.23 Debt 0 $928.23 PV of $120 for 12 years @7.5% All numbers are in thousands Adapted from exercise by A Damodaran 3

3 Correction: Convert Operating Leases to Assets (i.e., Capital Leases). Operating Lease: A contract to use an asset without ownership. Assets rented under operating leases include real estate, aircraft, and equipment with long, useful life spans such as vehicles, office equipment, and industry-specific machinery. Recorded as an expense on income statement. The leased asset and associated liabilities of future rent payments are not on the balance sheet (keeps the ratio of debt to equity low. Off-balance sheet financing). So nothing on balance sheet. Starbucks ROIC is lower than people think. Under a FASB rule effective Dec. 15, 2018, public companies must recognize all leases on the balance sheet unless they are shorter than 12 months. Capital Lease: Treated as ownership of asset purchased via a long-term loan. The asset is recorded on the balance sheet. And also a debt is recorded on balance sheet. Plus Asset depreciates over time and incurs an interest expense. So shows up in two ways on income statement.

4 Correction: Convert Operating Leases to Assets (i.e., Capital Leases).

Adjust the Financial Statements to Give a Steady-State Operating Picture Stated Adjusted Revenues $1,200 $1,200 - Operating lease expenses $120 Leases converted to financial expenses - Wages $200 $350 Hire a manager for $150,000/year - Material $300 $300 - Other operating expenses $180 $180 - Depreciation $77 PPE Gross divided by 12 Operating income $400 $293 - Interest expenses $0 $69 7.5% of $928.23 (see below) Taxable income $400 $223 - Taxes $160 $89 40% tax rate Net Income $240 $133 Debt 0 $928.23 PV of $120 for 12 years @7.5% PPE (gross) 0 $928.23 All numbers are in thousands Adapted from exercise by A Damodaran 4

4 Perpetual Growth With Fixed Reinvestment Is Important - But a Little Complicated. EPV was about zero growth and the operating assets being maintained but not increased. Growth usually requires adding to the operating assets. This means reinvestment and the return on that investment. So a simple definition is: Expected growth rate = Reinvestment rate * Return on capital If we assume a 2% growth rate in perpetuity and a 20% return on capital. RIR = g / ROC = 2% / 20% = 10% Reinvestment rate (RIR) = Changes in net working capital + (capex depreciation)

For Discount Rate, Use Cost of Capital For Now The discount rate is about the value of money. But it is also about opportunity cost. For now we will use the weighted average cost of capital. Cost of capital = 14.50% (100/114.33) + 4.50% (14.33/114.33) = 13.25% (The debt to equity ratio is 14.33%; the cost of capital is based on the debt to capital ratio) Can use reported operating income and lease expenses (treated as interest expenses) Coverage Ratio = Operating Income / Interest (Lease) Expense = 400,000/ 120,000 = 3.33 Rating based on coverage ratio = BB+ Default spread = 3.25% After-tax cost of debt = (Risk free rate + Default spread) (1 tax rate) = (4.25% + 3.25%) (1 -.40) = 4.50% Adapted from exercise by A Damodaran 4

Complete the Valuation Sofa Valuation Value = Expected FCFF next year / (cost of capital g) = Expected EBIT next year (1- tax rate)(1-rir)/(cost of capital g) Adjusted EBIT = $293,000 Tax rate = 40% Cost of capital = 13.25% Expected growth rate = 2% Reinvestment rate (RIR) = 10% Inputs to valuation = Expected FCFF next year / (cost of capital g) = Expected EBIT next year (1- tax rate)(1- RIR) / (Cost of capital g) = $296,000 (1.02) (1-0.4) (1-0.10) / (0.1325-0.02) = $1.434 million Value of equity = $1.434 million - $0.928 million (PV of leases) = $0.506 million Adapted from exercise by A Damodaran 4

Review of Operating Assets, Asset Valuation & EPV Perpetual Growth Exercise Corrections and Perpetual Growth Discount Rate vs. Cost of Capital (If Not in Lecture 1) Break - 15 min Operating Assets and Operating Liabilities Valuation Case Henkel The Forest For the Trees. A Pre-DCF Rant. DCF www.jeffreytowson.com 45

Standard Thinking On Discount Rates Text by A Damodaran 4

Capital Asset Pricing Model Is Most Common Model Expected Return Inputs Needed CAPM E(R) = Rf + b (R m - R f ) Risk free Rate Beta relative to market portfolio Market Risk Premium APM E(R) = Rf + Sb j (R j - R f ) Riskfree Rate; # of Factors; Betas relative to each factor Factor risk premiums Multi E(R) = Rf + Sb j (R j - R f ) Riskfree Rate; Macro factors factor Betas relative to macro factors Macro economic risk premiums Proxy E(R) = a + S b j Y j Proxies Regression coefficients Text by A Damodaran 4

Standard Thinking on Risk Estimation versus Economic uncertainty Estimation uncertainty reflects the possibility that you could have the wrong model or estimated inputs incorrectly within this model. Economic uncertainty comes the fact that markets and economies can change over time and that even the best models will fail to capture these unexpected changes. Micro uncertainty versus Macro uncertainty Micro uncertainty refers to uncertainty about the potential market for a firm s products, the competition it will face and the quality of its management team. Macro uncertainty reflects the reality that your firm s fortunes can be affected by changes in the macro economic environment. Discrete versus continuous uncertainty Discrete risk: Risks that lie dormant for periods but show up at points in time. (Examples: A drug working its way through the FDA pipeline may fail at some stage of the approval process or a company in Venezuela may be nationalized) Continuous risk: Risks changes in interest rates or economic growth occur continuously and affect value as they happen. Text by A Damodaran 4

More Risk Thinking Not all risk counts: While the notion that the cost of equity should be higher for riskier investments and lower for safer investments is intuitive, what risk should be built into the cost of equity is the question. Risk through whose eyes? While risk is usually defined in terms of the variance of actual returns around an expected return, risk and return models in finance assume that the risk that should be rewarded (and thus built into the discount rate) in valuation should be the risk perceived by the marginal investor in the investment The diversification effect: Most risk and return models in finance also assume that the marginal investor is well diversified, and that the only risk that he or she perceives in an investment is risk that cannot be diversified away (i.e, market or non-diversifiable risk). In effect, it is primarily economic, macro, continuous risk that should be incorporated into the cost of equity. Text by A Damodaran 4

5 Warren Buffett on Discount Rates We don t discount future cash flows at 9% or 10%; we use the U.S. treasury rate. We try to do deal with things about which we are quite certain. You can t compensate for risk by using a high discount rate.

5 Charlie Munger on Discount Rates we don t have a formula that will help you. And all that stuff is relevant. Opportunity cost, of course, is crucial. And, of course, the risk-free rate is a factor...different businesses get different treatments. They are all viewed in terms of value, and they re weighed one against another.

5 There Are Several Really Important Ideas Mixed Together Here - Discount Rate and Time Value of Money - Risk and Uncertainty - Opportunity Cost (and Hurdle Rate) - Cost of Capital

5 How much would you pay for 100RMB held in a safe for 1 year? How much would you pay for a promise from me to give you 100RMB in 1 year? How much would you pay for a promise from a guy on the street to give you 100RMB in 1 year? Do your answers change if you have only 300RMB to invest this month?

5 Cost of Capital: McKinsey Valuation Book Definition The cost of capital is the price charged by investors for bearing the risk that the company s future cash flows may differ from what they anticipate when they make the investment. It is the opportunity cost versus what investors can earn from investing in something else with the same risk. However If diversification reduces risk to investors and it is not costly to diversify, then investors will not demand a return for any risk they take that they can easily eliminate through diversification. They require compensation only for risks they cannot diversify away. The risks thy cannot diversify away are those that affect all companies for example, exposure to economic cycles. However, since most of the risks that companies face are in fact diversifiable, most risks don t affect a company s cost of capital. One way to see this in practice is to note the fairly narrow range of P/Es for large companies. Most large companies have P/Es between 12 and 20.

5 Damodaran: Weighted Average Cost of Capital (WACC)

5 The Easy Part: What Is the Cost of Debt? The cost of debt is the interest you pay. You can see the payments. A company has a $1 million loan with a 5% interest rate and a $200,000 loan with a 6% rate. It has also issued bonds worth $2 million at a 7% rate. The interest on the first two loans is $50,000 and $12,000, respectively, and the interest on the bonds equates to $140,000. The total interest for the year is $202,000. As the total debt is $3.2 million, the company's cost of debt is 6.31%. But don t riskier companies pay higher rates for debt? So doesn t the cost of capital increase with risk?

5 Why Do We Use After-Tax Cost of Debt? Interest expense is tax deductible. So you pay less taxes when you have debt. We see this on the income statements. But we removed the interest expense (we use EBIT(1-tax) because we don t want the ownership structure to change the value of the asset. Equity shareholders and all other ownership claims are after taxes. However, the tax benefit is real value. And we want to capture that. So we use after-tax cost of capital when figure out the invested capital. To calculate after-tax cost of debt, subtract a company's effective tax rate from 1, and multiply the difference by its cost of debt. Tax is more efficient as a source of capital (and cheaper) but it has more severe risks.

5 What is the Cost of Equity?

5 What is the Cost of Equity? This is After- Tax by Definition. Nobody knows. There is no explicit payment for equity cost like there is for interest. It s a fuzzy, made-up idea. You have to theorize, what would someone expect to be paid in order to let me use their money? Doesn t that kind of depend on who this person is? Would a grandma have the same cost of equity as a venture capital investor? Doesn t it depend on what the project is? Would a Shanghai real estate investor have the same cost of equity for buying a Shanghai apartment as buying an African insurance company? Cost of equity is generally a higher cost that debt because it doesn t have tax advantages. And because it generally gets a higher return. You can calculate it based on dividends paid. From NYU guy, you can also use the CAPM formula: Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return - Risk-Free Rate of Return). The risk-free rate is the rate of return paid on risk-free investments such as Treasuries. Beta is a measure of risk calculated as a regression on the company's stock price. The higher the volatility, the higher the beta and relative risk compared to the general market. In general, a company with a high beta, that is, a company with a high degree of risk, is going to pay more to obtain equity. The market rate of return is the average market rate, which has generally been assumed to be 11 to 12% over the past 80 years.

Standard Thinking On Discount Rates Calculated Fake Number Text by A Damodaran Made up number Made up number 6

Exercise: Calculate Weight Average Cost of Capital (WACC) of Coffee Shop Adjusted EBIT = $296,000 Tax rate = 40% Cost of equity = 14.5% Total equity Debt to equity ratio is 14.33% (or $14.33 of debt for every $100 of equity) Calculate Cost of Debt After-tax cost of debt = (Risk free rate + Default spread) (1 tax rate) Coverage Ratio = Operating Income/ Interest (Lease) Expense = 400,000/ 120,000 = 3.33 Rating based on coverage ratio = BB+ Default spread = 3.25% After-tax cost of debt = (Risk free rate + Default spread) (1 tax rate) = (4.25% + 3.25%) (1 -.40) = 4.50% Calculate weighted average cost of capital WACC = Cost of Equity (Equity/capital) + Cost of Debt (debt /capital) Cost of capital = 14.50% (100/114.33) + 4.50% (14.33/114.33) = 13.25% (The debt to equity ratio is 14.33%; the cost of capital is based on the debt to capital ratio) Adapted from exercise by A Damodaran 6

6 It Ain t What You Don t Know That Gets You Into Trouble, It s What You Know For Sure That Just Ain t So. - Mark Twain

6 There Are Several Really Important Ideas Mixed Together Here - Discount Rate and Time Value of Money - Risk and Uncertainty - Opportunity Cost (and Hurdle Rate) - Cost of Capital

6 So How Do You Decide the Discount Rate? Standard statement: the discount rate used should be consistent with both the riskiness and the type of cashflow being discounted. Common approach: To use WACC (this is McKinsey recommendation). And usually the CAPM. They argue you should compare the investment to the cost of the capital being deployed (so a mix of opportunity cost and hurdle rate). Other questions: Equity versus Firm? If the cash flows being discounted are cash flows to equity, the appropriate discount rate is a cost of equity. If the cash flows are cash flows to the firm, the appropriate discount rate is the cost of capital. Nominal versus Real? If the cash flows being discounted are nominal cash flows (i.e., reflect expected inflation), the discount rate should be nominal

6 Discount Rate Is Made of Multiple Factors Time value of money. This is a real and an important factor. A dollar in 5 years can purchase less than a dollar today. So is about value or about purchasing power? Isn t investing really about exchanging purchasing power today for greater purchasing power in the future? Risk-free rate is a good measure for this facto. Buffett says this affects all general assets. it is like gravity to all asset prices. Buffett: In order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value in our case, at the long-term Treasury rate by discounting your cash flows back at the long-term Treasury rate as a common yardstick just to have a standard of investment across all businesses We use the same discount rate across all securities. We may be more conservative in estimate cash in some situations. Just because the interest rates are at 1.5% doesn t mean we lie an investment that yields 2-3%...we re looking at holding it forever so we don t assume rates will always be this low.

6 Buffett Also Appears to Include Opportunity Cost in Discounting Opportunity cost Buffett s hurdle rate is his next best investment based on what is coming across his desk. I don t feel more comfortable buying that than I do of adding to Wells Fargo. Buffett This relates to hurdle rate. Usually companies have a rate or required return they must exceed to proceed. Usually exceeding the cost of capital is a minimum hurdle rate.

6 But Buffett Does Not Appear to Include Risk or Uncertainty in the Discount Factor

6 We don t formally have discount rates. Every time we start talking about this, Charlie reminds me that I ve never prepared a spreadsheet, but I do in my mind. We just try to buy things that we ll earn more from than a government bond the question is, how much higher? - Warren Buffett

6 Warren often talks about these discounted cash flow, but I ve never seen him do one. If it isn t perfectly obvious that it s going to work out well if you do the calculation, then he tends to go on to the next idea. - Charlie Munger

My Assessment of Buffett s Approach 1) Assemble options to invest that have a future that is quite certain and within his circle of competence. This is about reducing uncertainty (predictable companies) and risk (stay in your circle of competence) 2) Use the 30 year US Treasury rate to discount the DCF. This is a standard and reasonable yardstick for a fuzzy idea the time value (i.e., purchasing power) of money. Do not incorporate uncertainty or risk here. Just time value of money and opportunity costs. 3) Apply a margin of safety. This quantifies the risk of capital loss (the only risk that matters) 4) Compare the options available to you. This incorporates opportunity cost (and hurdle rate). DO NOT TRY TO ADJUST THE DISCOUNT RATE TO ACCOUNT FOR RISK. 7

7 Once you ve estimated future cash inflows and outflows, what interest rate do you use to discount that back to arrive at a present value? My own feeling is that the long-term government rate is probably the most appropriate figure for most assets. And when Charlie and I felt subjectively that interest rates were on the low side we might add a point or two generally If you do that, there is no difference in economic reality between a stock and a bond. - Buffett

7 We use the risk-free rate merely to equate one item to another we re looking for whatever is the most attractive And obviously we can always buy government bonds. Therefore, that becomes the yardstick rate. - Buffett

7 Each business has different characteristics and different risk profiles. You can t use the same discount rate for Microsoft as Coca-Cola. You have to consider all sorts of factors such as te predictability of the company, the risk profiles and etc. Obviously you ll use a higher discount rate for Microsoft It s a framework. Opportunity is a mental framework. Charlie Munger

7 My conclusion: A standard low discount rate makes sense when you are investing in highly certain businesses like Coca- Cola.

Review of Operating Assets, Asset Valuation & EPV Perpetual Growth Exercise Corrections and Perpetual Growth Discount Rate vs. Cost of Capital (If Not in Lecture 1) Break - 15 min Operating Assets and Operating Liabilities Valuation Case Henkel The Forest For the Trees. A Pre-DCF Rant. DCF www.jeffreytowson.com 75

Separate Out the Operating Engine THE OPERATING ENGINE Operating Assets and Operating Liabilities Net Operating Cash Flow After Taxes Remove interest (and its tax shield) Remove taxes on non-operating income Financial Assets and Stuff Excess cash and marketable securities Cross-holdings Financial assets Unused operating assets Excess pension funding Contingent liabilities (lawsuits) Underfunded pensions? Other? Equity and equity equivalents Page 76 Debt and debt equivalents Interest bearing liabilities Leases? View them as loans 76

Figure Out the Operating Working Capital From McKinsey & Co book 7

Figure Out the Operating Assets and Operating Liabilities From McKinsey & Co book 7

Figure Out the Operating Intangible Assets From McKinsey & Co book 8

8 How Do These Change in EPV? How Do They Change in Perpetual Growth?

Review of Operating Assets, Asset Valuation & EPV Perpetual Growth Exercise Corrections and Perpetual Growth Discount Rate vs. Cost of Capital (If Not in Lecture 1) Break - 15 min Operating Assets and Operating Liabilities Valuation Case Henkel The Forest For the Trees. A Pre-DCF Rant. DCF www.jeffreytowson.com 83

Separate Out the Operating Engine THE OPERATING ENGINE Operating Assets and Operating Liabilities Net Operating Cash Flow After Taxes Remove interest (and its tax shield) Remove taxes on non-operating income Financial Assets and Stuff Excess cash and marketable securities Cross-holdings Financial assets Unused operating assets Excess pension funding Contingent liabilities (lawsuits) Underfunded pensions? Other? Equity and equity equivalents Page 85 Debt and debt equivalents Interest bearing liabilities Leases? View them as loans 85

Contact Information: Jeffrey Towson Slides available at www.jeffreytowson.com