Value Drivers

What is Value ?

This is a short module on Introduction to Valuation. The online course is geared toward equity valuation, introducing concepts of value drivers’ Return on Invested Capital. This course shares an overview of types of valuation models, financial statements, capital, and risk structure. A brief understanding of fixed income, i.e., bonds, is included to facilitate valuing companies with debt. Valuation Measuring and Managing the value of companies by Tim Koller, Marc Goedhart, and David Wessels define value as Return on Invested Capital (ROIC) and Revenue Growth. It should be sustainable over time. The mathematically intrinsic value of an asset is the sum of the present value of future cash flows. Since future expected cash flows are uncertain, models assume future cash flows based on specific parameters. Both ROIC and Revenue Growth generate sustained cash flows. ROIC and Revenue Growth are important to understand the concept of free cash flows, a topic that will come as you advance in this online course. For a firm to be sustainable over the long term, Return on Invested Capital must be greater than the Cost of Capital. Its imperative to know the meaning of present value of money, to understand the method of discounting cash flows to arrive at the value of the asset. Apart from free cash flow, discounting factor is key to value an asset. Discounting factor for valuing assets would be cost of capital, it could be cost of equity or weighted average cost of capital (valuing both cost of equity and debt). Present value of money is important to comprehend due to uncertainty of future cash flows and time value of money due to inflation.  Inflation erodes the purchasing power of money, 100 units of a currency could buy more goods and services today than a year down the line assuming inflation. Deflations are a rare phenomena, refer to the online course on Macroeconomics to know more. 

Concept of Present Value

If the value of an investment is going to be 125 next year growing at the rate of 5%, what was the value of the investment now.

FV= PV(1+r)^ⁿ             where  FV=125

125=PV (1.05) here n=1

PV= 125/1.05= 119.05

Peek at Financial Statements 

Above example of an income statement – Microsoft Data Source: Microsoft

To understand more about these concepts, let’s take an overview of the three financial statements: Balance Sheet, Income Statement, and Cash Flow Statement.

Balance Sheet ==>   Information on assets and liabilities of the firm 

Income Statement ===>  Discusses revenues and expenses of the firm and income of firms over a period of time 

Cash Flow Statement ===>   Sources of cash in a firm from operating, investing and financing activities. 

Note: Net operating profit is part of the income statement while working capital and fixed assets are on the balance sheet.

Return on Invested Capital (ROIC) is Net Operating Profit less adjusted for Tax (NOPLAT) divided by Invested Capital.

Invested Capital refers to the cumulative capital invested in core operations with a focus on capital-intensive materials example property, plant and machinery, and working capital. Working Capital is the investment required for running the operations of the company. When valuing companies using discounted cash flow model, an increase in investment capital over time is taken as a capital outflow. Net Investment is an increase in capital over a consecutive period. Invested capital is a sum of working capital and fixed assets. NOPLAT emphasizes profits generated are from the core operations of the company, a key measure to understanding how well your firm is performing. Example for a technology company revenues from its technology division. 

NOPLAT is also EBIT (1- Tax Rate), where EBIT is earnings before interest and tax. EBIT is part of the income statement, a critical financial statement tool. The other financial statements are the balance sheet and cash flow statement.    

FCF = NOPLAT – Net Investment  

(FCF = free cash flow) A more detailed overview of free cash flow is discussed ahead.

The following example is very similar to the one discussed in the McKinsey book, used to explain the relationship between cash flow and investment. There are two companies with similar revenue and earnings.

Cash Flow = Earnings – Investment. Fig 1

If you compare fig 1 and 2 for both companies, the cost of capital is 8% which is discounted to calculate the present value of future expected cash flows. The value of Company B is higher than Company A as company B can generate similar cash flows as company A keeping other factors constant with less investment. Therefore, Company B is the better of the two companies in generating value. Assume cash flow as free cash flow with earnings as net operating profit post-tax or EBIT (1-tax rate). B is generating superior ROIC compared to A. In this case, it could be due to its dominant position in the market. ROIC is not affected by the capital structure of the company, but rather a barometer of business performance. 

Fig 2 

Understanding Cash Flow

A simplified example to calculate the cash flow. Consider the revenues of the firm to be 200. Revenues is the total value of products or services sold by a firm in a calendar year. Earnings are net operating profit adjusted for tax, the cash flows are 55 i.e. 100 -45 = 55 

Cash Flow = Earnings – Investment. 

If the earnings increase to 120 next year, what is return on invested capital?  Assume, percent change in investment is 45%

% Change in earnings = (120-100)/100 =20%

ROIC= % change in earnings growth/ % change in investment

ROIC  =  20/45= 44.4%

Investment Rate is important, it ties Growth, ROIC and Cash Flow

Investment Rate= Growth/ROIC  = % Change in Earnings/ROIC

=20%/44.4%     = 45%

Next Overview of Financial Statements