How Can a Company Create Value?

1. Discuss, with the aid of examples, how a company can create value

THEORETICAL BASIS FOR VALUE CREATION

Companies create value by investing capital to generate future cash flows through its business operations at a rate exceeding the cost of capital. Numerically, the value of a company can be defined as the sum of present values of free cash flows (FCF) expected in the future, and is given by the mathematical expression,

where FCFt is the free cash flow in year t, and WACC is the weighted average cost of capital. This can be simplified into the expression,

where NOPLAT1 is the net operating profit less adjusted taxes in the first year, ROIC is the return on invested capital, and g is the annual rate at which FCF grows (Koller, 2010). When the investment rate is constant and NOPLAT is proportional to the revenues, the revenues of a company will also grow at the same rate g as the cash flows. Thus from the above expression, the value of a company is driven by its revenue growth (g) and the return of invested capital (ROIC). Figure 1 shows a contour plot of value vs. growth and ROIC with a NOPLAT of 100 and WACC at 10%.

Figure 1: Contour Plot of Value vs. g and ROIC

It is clear from the contour plot that higher growth leads to increase in value, but only when ROIC is greater than WACC. It is also evident from the arrows on Fig.1 that in order to create value, higher growth companies should focus on increasing ROIC and higher ROIC companies focus on growth.

From the above theoretical basis, it is evident that in order to increase their value, companies must undertake activities that result in growing the business and/ or increasing the return on invested capital (ROIC) as appropriate, while avoiding short-term growth in free cash flows (and dividends) achieved by cutting down on investments that could increase the value on a longer term. As a corollary, if a company undertakes actions that do not produce incremental cash flows, then there is no additional value created. Activities such as share repurchases and financial engineering do not generally create value for this reason. Grullion and Michaely have demonstrated statistically that dividends and repurchases are substitutes (2002, p.1682). However share repurchases could help avoid value destruction, when a company has a high likelihood of investing cash at low returns (Koller, 2010).

EXAMPLES OF ACTIVITIES UNDERTAKEN BY COMPANIES TO CREATE VALUE

Gaining Competitive Advantage

A company’s ROIC depends directly on its competitive advantage enabling it to charge a price premium on its products and services or produce them more efficiently (at lower cost or lower capital), or both. Companies can charge a price premium if they produce innovative and high quality products, build a great brand and through customer lock-in. In commodities or commoditised products and services, rational price discipline by the players in the industry can help keep up the lower bound on prices. Cost and capital efficiencies can be built through innovative business and operating models, leveraging economies of scale and through scalable products.

Product Innovation. Tesla Motors’ electric cars are good examples of product innovation as a strategy adopted by a company. Their Model S has economy, performance and range (over 200 miles) as the key differentiating factors over other competitors, with a price premium well over $25,000 on comparable electric cars (Davis, 2013).

Product Quality. While reputation for quality products helps to charge a price premium (as in the case of BMW and Audi cars), product quality programmes such as Six Sigma have been demonstrated to reduce unit cost of products/ services in Bank One, Lockheed Martin, Stanford Hospital and Clinics and of course General Electric (George, M., 2003).

Brand Creation. Samsung spent over $4.3 billion in advertising, ranking in brand value at 9 from 53 (Forbes). Their products such as Ultrabooks demand premiums prices well over the other competitors and on par with Apple’s laptops. Brands also drive volumes as evidenced by Coca-cola and McDonalds, leading to value creation through economies of scale (Forbes).

Innovative Business Methods. Structuring the business model and operations to reduce waste and complexity can result in significant cost efficiencies. Southwest Airlines avoided complexity by operating only one type of aircraft (Boeing 737) in contrast to American Airlines which operated up to 14 different types of aircraft during 1996-2001. As a result, Southwest had about 40% lesser cost of airline operations per seat-mile during in 2001 compared to American Airlines, while its share price doubled (George, M., 2004, p.6-8)

Growth Initiatives

When ROIC is high, growth drives value quickly as seen in Figure 1. The following are a couple of examples of how companies create value through growth

Create New Markets There is perhaps no better example than tablet computers for the creation of a new market. Apple identified a market gap and released a revolutionary new product, iPad. Within the first quarter, iPad became Apple’s third largest revenue segment surpassing iPod (https://www.businessinsider.com/chart-of-the-day-ipad-ipod-mac-2010-7).

Persuade existing customers to buy more Insurance companies such as Aviva offer loyalty discounts to persuade its car insurance customers to buy home of life insurance thus driving growth. Technology companies such as Samsung attract customers to buy other products such as Galaxy Gear watch by offering integration with its phones. Also, technology companies persuade their customers to buy compatible accessories for phones and tablets.

Granular growth In order to determine the areas of growth within the portfolio, a high level cut by business or geography is not sufficient. According to Baghai (2009, p.88-89), a granular analysis to identify micro-segments of customers, geographies, regions and products is essential, before investing in R&D, advertising and other growth investments. Baghai gives an example of a semiconductor manufacturer who reallocated 30% of R&D resources to highly promising segments resulting in faster than the market growth within two years.

Mergers & Acquisitions Jack Welch, the CEO of General Electric during 1981-2001 adopted a “fix, sell or close” strategy for underperforming business units. In the first four years of his tenure, he divested 117 business units, accounting for 20% of GE’s assets. It is well known the GE’s share during his 20 year tenure rose by 4000%. According to a study performed on 200 companies during 1900-2000, on an average, $100 invested in January 1990 in a company actively managing its business portfolio would be worth $459 by the end of the decade, while that same $100 would have grown to only $353 if invested in company passively managing its business portfolio (Dranikoff, 2002, p.75-76). This approach to fix, sell or close based on value can be applied to the portfolio of products and service offerings of a company in order to increase its value.

2. Explain how to value companies using the cash flow-based approach and the difficulties that may arise in the application of such an approach in the real-world.

The enterprise DCF method discounts free cash flows (FCF), available to all investors including equity holders, debt holders and non-equity investors, at the weighted average cost of capital (WACC). Enterprise DCF method is a carried out as shown in the process below (Koller, 2010):

• Determine the value operations of a company by discounting FCF at WACC
• Identify and value non-operating assets such as nonconsolidated subsidiaries, equity investment, and add it to the value of operations to obtain the enterprise value
• Identify and value all debt and non-equity claims such as unfunded pension liabilities, employee stock options, etc.
• Subtract the non-equity value from the enterprise value to obtain equity value. Calculate the price per share by dividing the equity value by current number of undiluted shares.

Valuing Operations Using DCF method to value operations requires a forecast of future FCF and WACC at which cash flows must be discounted. Historical values of FCF and WACC are necessary before they could be forecasted. To calculate FCF for past and current years, NOPLAT and change in Invested Capital are obtained first from the rearranged financial statements, from which FCF is derived. ROIC is then calculated as the ratio of NOPLAT to the Invested Capital. The figures thus obtained are used to perform historical analysis of the company, especially to understand how the value drivers, namely ROIC and growth have behaved in the past, in order to estimate their future values.

Forecasts for ROIC and growth are determined using sell-side analysis. FCF forecasts are obtained from the forecasts for NOPLAT and Invested Capital derived. A major difficulty in this process is that these forecasts cannot be projected beyond a few years. Therefore, the Continuing Value of the company must be added to the Present Value of the FCF projected for the forecasted years. The value of the operations thus determined is given by the expression (Koller, 2010):

Value of Operations = PV of FCF during forecast period + Continuing Value (which is the PV of FCF during the years beyond the forecast period).

NOPLAT in the year following the forecast period is required to calculate Continuing Value. RONIC (return on new capital) and growth (g) are calculated as long run forecasts.

WACC is required both to discount cash flows during the forecast period as well as to determine the continuing value. It is calculated as a blended rate of the cost of capital of equity (ke) and debt (kd).

Koller (2010, p.113) gives the following expression for WACC:

where D is the debt and E the equity of a company at market values, while Tm is the marginal tax rate. Applying a constant WACC to determine the present value of all future cash flows is based on the assumption that the capital structure (debt to equity ratio) is constant throughout the future. This is however not true in real life. WACC can be adjusted to account for the lack of stability in debt to equity ratio, but the process is very complicated. Instead, it is recommended that Adjusted Present Value (APV) method be used in such circumstances (Koller, 2010).

Some of the real world problems faced while valuing companies could be summarised as below:

• Company financial statements provide only historical data while DCF method requires future projections of FCF and WACC. It is not easy to obtain forecasts beyond a few years
• Assuming WACC to be constant throughout is not realistic and can skew the results
• Significant changes in debt to equity ratio can make cash flow based valuation a very difficult exercise

According to Jacobs and Shivdasani (2012. p.119-124), the following are some specific practical issues identified in a survey conducted by Association for Finance Professionals (AFP):

• Forecast horizon varies significantly among the practitioners (5-15 years)
• While cost of equity (required to calculate WACC) is estimated using Capital Asset Pricing Model (CAPM) by most respondents, the definitions of factors used in this method, viz., risk free rate, market premium and beta varied significantly (eg. beta period from 1-5 years).
• Similarly, inconsistent definitions of cost of debt (required for WACC calculation) were reported to be used by the respondents
• Nearly 50% of the respondents of a survey conducted by Association of Finance Professionals (AFP) admitted that the discount rate (WACC) they use is likely to be 1% more or less than the company’s true rate. This becomes a key issue in valuation as it has been shown that a 1% drop in the cost of capital could influence the US companies to invest an additional $150 billion over three years.
• Over half of the respondents have using book value of equity instead of market value to calculate debt to equity ratio (required for WACC). But in real life the difference can be 10 fold (eg. IBM, Delta Airlines) resulting in WACC to be underestimated by about 2-3%.

Valuation of Non-Operating Assets

Enterprise value is obtained by adding the value of non-operating assets to the operating value. Non-operating assets include non-consolidated subsidiaries, excess cash, tradable securities and customer financing arms. Net income from non-consolidated subsidiaries cannot be included in the free cash flows to calculate value as it will distort the margins due to the fact that the corresponding revenues are not recognised in this calculation. Therefore, they must be valued separately. A practical difficulty in this process is the level of accuracy in estimating the value of non-consolidated subsidiaries due to the fact that it depends on how much other companies owing these subsidiaries disclose the required information (Koller, 2010).

Identifying and Valuing Non-equity Claims

In order to obtain equity value, the value of non-equity claims (such as interest bearing debt, unfunded pensions, capitalised operating leases and employee stock options) must be subtracted from the enterprise value. Due to increasingly complex financial markets, it is very difficult to identify certain non-equity claims such as Special Investment Vehicles (SIV) in real life, since SIVs are registered as separate legal entities and the originating banks are not contractually responsible for the debt.

References

Baghai, M., Smit, S., and Viguerie, P . ‘Is Your Growth Strategy Flying Blind?’, Harvard Business Review, May 2009.

Davies, A. and Nudelman, M. 'Here's How Tesla's Model S Compares To Other Top Electric Cars', Business Inisder. Available from: https://www.businessinsider.com/electric-car-comparison-chart-2013-8) [Accessed 01 March 2014].

Dranikoff, L., Koller, T. and Schneider, A. ‘Divestiture: Strategy’s Missing Link’, Harvard Business Review, May 2002

Forbes, 2014. ‘The World’s Most Valuable Brands’. Available from: https://www.forbes.com/powerful-brands/list/ [Accessed 03 March 2014].

Frommer D., 2010. ‘CHART OF THE DAY: The iPad Is Already Bigger Than The iPod -- And Half As Big As The Mac. Available from https://www.businessinsider.com/chart-of-the-day-ipad-ipod-mac-2010-7 [Accessed 03 March 2014].

George, M. and Wilson, S., 2004. Conquering Complexity In Your Business. 1st ed. London: McGraw-Hill.

George, M., 2003. Lean Six Sigma for Service. 1st ed. New York: McGraw-Hill.

Grullion, G. and Michaely, R., 2002. ‘Dividends, Share Repurchases, and the Substitution Hypothesis’. Journal of Finance, Vol LVII, No.4.

Jacobs, M. and Shivdasani, A. ‘Do You Know Your Cost Of Capital?’, Harvard Business Review, July-Aug 2012, p.119-124.

Koller, T., Goedhart, M. and Wessels, D., 2010. Valuation: Measuring and Managing the Value of Companies. 5th ed. New Jersey: John Wiley.

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