Corporate Valuation
Lecture 1 – Principles of Value Creation
Principles of Valuation
First Principles:
Corporate Finance: First Principles:
The Investment Recommendation:
Stock prices seem not determined by underlying company value but by market sentiment.
Plenty people feel this way.
Philosophy of valuation:
“Valuation is often not a helpful tool in determining when to sell hyper-growth stocks.”
-Henry Blodget, Merrill Lynch Equity (January 2000, in a report on Internet Capital Group,
which was trading at $174 then). Was very wrong.
There have always been investors in financial markets who have argued that market prices
are determined by the perceptions (and misperceptions) of buyers and sellers, and not by
anything as down to earth as cashflows or earnings.
Perceptions matter, but they cannot be all that matters. You do need something to back up
your valuation, needs to be some repayment of your investment.
Asset prices cannot be justified by merely using the “bigger fool” theory.
Postscript: Internet Capital Group was trading at $3 in January 2001.
,The Guiding Principle of Value Creation:
- Companies that grow and earn a return on capital that exceeds their cost of capital
create value!
- Creating shareholder value is not the same as maximizing short-term profits!
- A system that focused on creating shareholder value isn’t the problem; short-
termism is!
- Empirically, long-term revenue growth is the most important driver of shareholder
returns for companies with high return on capital!
The Firm and Financial Markets:
Companies Key Decisions:
The financial position of a company is defined by two equal sides:
Assets: What the enterprise owns. The resources with which it will create value for
customers.
- Assets = A resource controlled by the entity as a result of past events and from which
future economic benefits are expected to flow to the entity.
Equity and liabilities: Obligations the entity has towards shareholders and third parties. The
sources of financing for the assets.
- Liabilities = A present obligation of the entity arising from past events, the settlement
of which is expected to result in an outflow from the entity of resources embodying
economic benefits.
- Equity = The residual interest in the assets after deducting all liabilities.
Main Principles of Valuation:
We buy financial assets for their expected cash flows:
- Value needs to be backed by reality;
- Can’t justify any price just because someone will buy it;
- Should not pay for an asset more than it is worth.
,What determines value?
Return on
invested
capital
Cash flow
Revenue
Value
growth
Cost of capital There is value when your
return on invested capital is
larger than the cost of invested capital. This is influenced by growth. Typically, when the
return is larger than the cost of capital and there is growth, you will generate value.
Growth and ROIC
What is value?
- A company is a collection of assets.
- The value of an asset is equal to the net sum of the present values of future expected
cashflows.
- Or the difference between cashflows and the cost of investment made, adjusted for
time value of money and risk.
- Cashflows are a function of return on invested capital and revenue growth.
Growth and ROIC Drive Value:
The amount of value a company creates is directed by its ROIC and revenue growth and the
ability to sustain both over time.
Only if ROIC exceeds cost of capital will growth increase a company’s value. Growth at lower
returns actually reduces a company’s value.
Typically, high-ROIC companies create more value by focusing on growth, while lower-ROIC
companies create more value by increasing ROIC.
Discounted Cash Flow Valuation:
What is it: In discounted cash flow valuation, the value of an asset is the present value of the
expected cash flows on the asset.
Philosophical Basis: Every asset has an intrinsic value that can be estimated, based upon its
characteristics in terms of cash flows, growth and risk.
Information Needed: To use discounted cash flow valuation, you need to:
- Estimate the life of the asset;
- Estimate the cash flows during the life of the asset;
- Estimate the discount rate to apply to these cash flows to get present value.
Market Inefficiency: Markets are assumed to make mistakes in pricing assets across time,
and are assumed to correct themselves over time, as new information comes out about
assets.
, Advantages of DCF Valuation:
- Since DCF valuation, done right, is based upon an asset’s fundamentals, it should be
less exposed to market moods and perceptions.
- If good investors buy businesses, rather than stocks (the Warren Buffet adage),
discounted cash flow valuation is the right way to think about what you are getting
when you buy an asset.
- DCF valuation forces you to think about the underlying characteristics of the firm,
and understand its business. If nothing else, it brings you face to face with the
assumptions you are making when you pay a given price for an asset.
Disadvantages of DCF Valuation:
- Since it is an attempt to estimate intrinsic value, it requires far more inputs and
information than other valuation approaches.
- These inputs and information are not only noisy (and difficult to estimate), but can be
manipulated by the analyst to provide the conclusion he or she wants.
- In an intrinsic valuation model, there is no guarantee that anything will emerge as
under or overvalued. Thus, it is possible in a DCF valuation model, to find every stock
in a market to be overvalued. This can be a problem for:
Equity research analysts, whose job it is to follow sectors and make
recommendations on the most under- and overvalued stocks in that sector;
Equity portfolio managers, who have to be fully (or close to fully) invested in
equities.
DCF works best when:
DCF is easiest to use for assets (firms) whose:
- Cashflows are currently positive, and;
- Can be estimated with some reliability for future periods, and;
- Where a proxy for risk that can be used to obtain discount rates is available.
It works best for investors who either:
- Have a long time horizon, allowing the market time to correct its valuation mistakes
and for price to revert to “true” value, or;
- Are capable of providing the catalyst needed to move price to value, as would be the
case if you were an activist investor or a potential acquirer of the whole firm.
Cash Flows ≠ (Earnings) Growth:
Value = earnings
growth:
Only if all firms in the
industry earn the
same return on
invested capital and are equally risky!
Lecture 1 – Principles of Value Creation
Principles of Valuation
First Principles:
Corporate Finance: First Principles:
The Investment Recommendation:
Stock prices seem not determined by underlying company value but by market sentiment.
Plenty people feel this way.
Philosophy of valuation:
“Valuation is often not a helpful tool in determining when to sell hyper-growth stocks.”
-Henry Blodget, Merrill Lynch Equity (January 2000, in a report on Internet Capital Group,
which was trading at $174 then). Was very wrong.
There have always been investors in financial markets who have argued that market prices
are determined by the perceptions (and misperceptions) of buyers and sellers, and not by
anything as down to earth as cashflows or earnings.
Perceptions matter, but they cannot be all that matters. You do need something to back up
your valuation, needs to be some repayment of your investment.
Asset prices cannot be justified by merely using the “bigger fool” theory.
Postscript: Internet Capital Group was trading at $3 in January 2001.
,The Guiding Principle of Value Creation:
- Companies that grow and earn a return on capital that exceeds their cost of capital
create value!
- Creating shareholder value is not the same as maximizing short-term profits!
- A system that focused on creating shareholder value isn’t the problem; short-
termism is!
- Empirically, long-term revenue growth is the most important driver of shareholder
returns for companies with high return on capital!
The Firm and Financial Markets:
Companies Key Decisions:
The financial position of a company is defined by two equal sides:
Assets: What the enterprise owns. The resources with which it will create value for
customers.
- Assets = A resource controlled by the entity as a result of past events and from which
future economic benefits are expected to flow to the entity.
Equity and liabilities: Obligations the entity has towards shareholders and third parties. The
sources of financing for the assets.
- Liabilities = A present obligation of the entity arising from past events, the settlement
of which is expected to result in an outflow from the entity of resources embodying
economic benefits.
- Equity = The residual interest in the assets after deducting all liabilities.
Main Principles of Valuation:
We buy financial assets for their expected cash flows:
- Value needs to be backed by reality;
- Can’t justify any price just because someone will buy it;
- Should not pay for an asset more than it is worth.
,What determines value?
Return on
invested
capital
Cash flow
Revenue
Value
growth
Cost of capital There is value when your
return on invested capital is
larger than the cost of invested capital. This is influenced by growth. Typically, when the
return is larger than the cost of capital and there is growth, you will generate value.
Growth and ROIC
What is value?
- A company is a collection of assets.
- The value of an asset is equal to the net sum of the present values of future expected
cashflows.
- Or the difference between cashflows and the cost of investment made, adjusted for
time value of money and risk.
- Cashflows are a function of return on invested capital and revenue growth.
Growth and ROIC Drive Value:
The amount of value a company creates is directed by its ROIC and revenue growth and the
ability to sustain both over time.
Only if ROIC exceeds cost of capital will growth increase a company’s value. Growth at lower
returns actually reduces a company’s value.
Typically, high-ROIC companies create more value by focusing on growth, while lower-ROIC
companies create more value by increasing ROIC.
Discounted Cash Flow Valuation:
What is it: In discounted cash flow valuation, the value of an asset is the present value of the
expected cash flows on the asset.
Philosophical Basis: Every asset has an intrinsic value that can be estimated, based upon its
characteristics in terms of cash flows, growth and risk.
Information Needed: To use discounted cash flow valuation, you need to:
- Estimate the life of the asset;
- Estimate the cash flows during the life of the asset;
- Estimate the discount rate to apply to these cash flows to get present value.
Market Inefficiency: Markets are assumed to make mistakes in pricing assets across time,
and are assumed to correct themselves over time, as new information comes out about
assets.
, Advantages of DCF Valuation:
- Since DCF valuation, done right, is based upon an asset’s fundamentals, it should be
less exposed to market moods and perceptions.
- If good investors buy businesses, rather than stocks (the Warren Buffet adage),
discounted cash flow valuation is the right way to think about what you are getting
when you buy an asset.
- DCF valuation forces you to think about the underlying characteristics of the firm,
and understand its business. If nothing else, it brings you face to face with the
assumptions you are making when you pay a given price for an asset.
Disadvantages of DCF Valuation:
- Since it is an attempt to estimate intrinsic value, it requires far more inputs and
information than other valuation approaches.
- These inputs and information are not only noisy (and difficult to estimate), but can be
manipulated by the analyst to provide the conclusion he or she wants.
- In an intrinsic valuation model, there is no guarantee that anything will emerge as
under or overvalued. Thus, it is possible in a DCF valuation model, to find every stock
in a market to be overvalued. This can be a problem for:
Equity research analysts, whose job it is to follow sectors and make
recommendations on the most under- and overvalued stocks in that sector;
Equity portfolio managers, who have to be fully (or close to fully) invested in
equities.
DCF works best when:
DCF is easiest to use for assets (firms) whose:
- Cashflows are currently positive, and;
- Can be estimated with some reliability for future periods, and;
- Where a proxy for risk that can be used to obtain discount rates is available.
It works best for investors who either:
- Have a long time horizon, allowing the market time to correct its valuation mistakes
and for price to revert to “true” value, or;
- Are capable of providing the catalyst needed to move price to value, as would be the
case if you were an activist investor or a potential acquirer of the whole firm.
Cash Flows ≠ (Earnings) Growth:
Value = earnings
growth:
Only if all firms in the
industry earn the
same return on
invested capital and are equally risky!
