Valuation: Measuring and Managing the Value of Companies

I’m currently reading through the book “Valuation: Measuring and Managing the Value of Companies by McKinsey & Company”. The following will be my notes and reflections / learnings following each chapter of the book. As this is my first time reading the book, I might not fully understand the concepts and may miss out on some key points. However, I intend to revisit this book multiple times in the future and update the page accordingly. This will be purely for my own learning and journalling purposes, but it’ll be nice if it helps someone else out there as well.

Chapter 1: Why Value Value?

Good management does not seek to please the short-term focus of Wall Street, and do not make decisions that favour quarterly / short term reports at the expense of long-term value creation. They might face consequences such as a sharp drop in stock price and reduced near-term financial incentives, but they should remain unfazed and tide through these periods rationally, stoically.
It’s important for investors to investigate and study the mindset of management. We are not employees, and this information isn’t usually readily available as it appeals to a very specific niche of investors. So we have to study the decisions that management made in the past, and see if the managers are making the right trade-offs between short-term and long-term value creation. This presents a valuable opportunity, especially when management is making the right decisions. Even though Wall Street may punish the stock for poor short-term performance, we can seize the chance to buy additional shares at a discounted valuation with greater conviction. This is the essence of being contrarian.
“The faster companies can increase their revenues and deploy more capital at attractive rates of return, the more value they create. … Anything that doesn’t increase ROIC or growth at an attractive rate of return does not create value.”
“Only if companies have a well-defined competitive advantage can they sustain strong growth and high returns on invested capital. … companies must continually seek and exploit new sources of competitive advantage if they are to create long-term value.”
“Managers must resist short-term pressure to take actions that create illusory value quickly at the expense of the real thing in the long term.”

Chapter 2: Finance in a Nutshell

ROIC > WACC = Value Creation. Always.
Economic profit is defined as the spread between ROIC and WACC, multiplied by the amount of capital employed. This gives us the same valuation as the discounted cash flow model.
If ROIC < WACC and the company pushes for growth, it’s destroying value.
DCF: Project into the future at ROIC, discount back at WACC.
Select projects that maximise Net Present Value of expected future cash flows.
“The returns that shareholders earn depend on changes in expectations as much as on the actual performance of the company.”
Tie management compensation to targeted NPV or economic profit.
Do not focus solely on ROIC. It’s key to maximise the combination of ROIC and the amount of capital employed. This helps to maximise economic profit.

Chapter 3: Fundamental Principles of Value Creation

The conversion of revenues into cash flows — and earnings — is a function of a company’s return on invested capital and its revenue growth.
High ROIC companies typically create more value by focusing on growth, while lower-ROIC companies create more value by increasing ROIC.
Anything that does not increase cash flows does not increase the value of the company.
Since accounting earnings may not always translate into cash flows, focusing too much on accounting earnings growth will cause a company to stray from value creation.
Free cash flow is the cash leftover for investors once investments have been subtracted from operating cash flows.
Note: Earnings are used synonymously with NOPAT (Net Operating Profit After Tax) in this book.
As growth slows at any level of ROIC, the cash generated per dollar of NOPAT increases. Taking ROIC constant, this means that the investment rate decreases as growth slows, so more cash is available for distribution to shareholders.
This explains why companies with high ROIC but slowing growth can pay out much larger amounts of their earnings to investors. This is what we want to maximise in a company — the amount of cash available for distribution once it has maximised its growth potential and starts returning cash to shareholders.
Improving ROIC for any level of growth always increases value because it reduces the investment required for growth. i.e. less capital needs to be reinvested to obtain the same growth rate.
“Don’t fall for the trap that growth will lead to scale economies that automatically increase a company’s return on capital. It almost never happens for mature businesses.”
You want to own a company that can grow at the same rate as its competitors with relatively little capital investment. This means you want a company with a relatively high ROIC. This translates to more cash available for distribution to shareholders, and assuming the high ROIC can be maintained or improved as the reinvestment rate increases, the company can grow at a faster rate than its competitors.
In general, companies already earning a high ROIC can generate more additional value by increasing their rate of growth, rather than their ROIC. For their part, low-ROIC companies will generate relatively more value by focusing on increasing their ROIC.
Important to consider return on incremental invested capital (ROIIC) as the ROIC of incremental investments may decrease as the company grows. This is because the company may have to invest in less attractive projects as it grows, which may decrease the overall ROIC of the company. “Different types of growth earn different returns on capital, so not all growth is equally value creating.” But it’s fine to grow as long as the ROIIC remains above the WACC.
Growth strategies based on organic new-product development frequently have the highest returns because they don’t require much new capital. What’s more, the investments to create new products are not required all at once, so the downside risk is limited. On the contrary, acquisitions require large amounts of capital upfront and are often riskier in terms of the amount of value it’ll create (although one could argue that acquisitions bring along its own revenue earnings which can pad the downside risk).
Only strive for growth if ROIC > WACC.
Value creation is strongly correlated to total shareholder return (TSR). TSR is the sum of the change in stock price and dividends paid to shareholders.
Even if ROIC declines over time, as long as it’s above WACC, value is created. Do not be afraid to push for growth at the expense of ROIC, so long as ROIC remains above WACC. This helps maximise the value created by the company.
Small startups could possibly increase ROIC over time by pushing for growth. (Think Grab, providing huge initial discounts that likely generate short term ROIC < WACC, but as they scale and increase their ROIC, they gain more market share, develop their brand value, and ROIC improves over time.) This is not likely the same with mature companies.
Rule: Low ROIC companies should prioritise increasing ROIC over growth. High ROIC companies should prioritise growth over increasing ROIC.
The method to increase ROIC matters too. We can either improve the operating margin or the capital productivity (i.e., using less working capital). For low ROIC, margin improvement provides a slight advantage relative to capital productivity in terms of value creation. For high ROIC, margin improvement provides a substantial advantage relative to capital productivity for increasing value.
- Value creation derived from capital productivity only allows for a one-time increase in cash flows and thus improving ROIC only once. Think of working capital as a temporary bank account used to finance current operations. Reducing the amount by $x dollars only allows for a one time increase in cash flows by $x dollars.
- On the other hand, value creation derived from margin improvement allows for a continuous increase in cash flows. If we improve operating margins (i.e., use technology to increase efficiency), the cost savings and operating margin is likely to maintain over time thus driving an increase in cash flows in the years to come, and not as a one-time increase.
- Moral of the story, prioritise margin improvements over capital productivity when improving ROIC.
Share dilution leads to reduced cash flows per shareholder. This happens often due to outsized compensation packages for management without a proportionate share-buyback program.
“In every circumstance, executives should focus on increasing cash flows rather than finding gimmicks that merely redistribute value among investors or make reported results look better. … If you can’t pinpoint the tangible source of value creation, you’re probably looking at an illusion …”
Share buybacks are value destroying if the returns on the buybacks are less than the WACC or less than the alternative opportunities. This is because the company is essentially buying back shares at a price higher than the intrinsic value of the company. This is why it’s important to have a disciplined approach to share buybacks. A company should never buy back shares just to support the stock price and boost earnings per share. It should only do so if the shares are undervalued. Treat share buybacks as if another investment opportunity.
A company borrowing money to buy back shares will likely lead to a lower increase in earnings relative to the percentage of shares bought back due to the cost of borrowing.
“Share repurchases increase EPS immediately, but possibly at the expense of lower long-term earnings.”
Acquisitions create value only when the combined cash flows of the two companies increase (prevAcquirerCF + prevAcquiredCF < combinedCompaniesCF) due to cost reductions, accelerated revenue growth (i.e., due to synergies and cross-selling), or better use of fixed and working capital (i.e., share inventory, economies of scale).
Be wary of financial engineering (defined in the book as “the use of financial instruments or structures other than straight debt and equity to manage a company’s capital structure and risk profile) as it’s often a way to make financial statements pretty without underlying substance. Always go back to projecting future cash flows.
A mature company is expected to have high ROICs. If a mature company has low ROICs, this implies that the company likely has a flawed business model or unattractive industry structure.
Definitions:
1. Net operating profit after taxes (NOPAT): Profits generated from the company’s core operations after subtracting the income taxes related to those core operations.
2. Invested capital: Cumulative amount the business has invested in its core operations—primarily property, plant, and equipment and working capital.
3. Net investment: The increase in invested capital from one year to the next.
```
Net Investment = Invested Capital at t+1 - Invested Capital at t
```
4. Free cash flow (FCF): Cash flow generated by the core operations of the business after deducting investments in new capital.
```
FCF = NOPAT - Net Investment
FCF = NOPAT * (1 - Investment Rate) # alternative formula
FCF = NOPAT * (1 - Growth / ROIC) # alternative formula
```
5. Return on invested capital (ROIC): Return the company earns on each dollar invested in the business.
```
ROIC = NOPAT / Invested Capital
```
6. Investment Rate (IR): The portion of NOPAT invested back into the business.
```
IR = Net Investment / NOPAT
IR = Growth / ROIC # if we assume a constant ROIC and growth rate
```
7. Weighted average cost of capital (WACC): 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.
8. Growth (g): Is the rate at which the company’s NOPAT and cash flow grow each year.

Mathematical Formulas:

Assuming a constant ROIC and growth rate:

# Valuation multiple that we can use to compare across companies. 
# The higher the better. Good alternative to standard earnings 
# multiple like the P/E ratio.
Value per dollar of Invested Capital = ROIC * 
                                       [
                                        (1 - Growth / ROIC) / 
                                        (WACC - Growth)
                                       ] 

# Use this instead of the above if ROIIC != ROIC.
Value per dollar of Invested Capital = ROIC * 
                                       [
                                        (1 - Growth / ROIIC) / 
                                        (WACC - Growth)
                                       ] 

# DCF formula. Useful to see what generates value. 
# Derived from everything else. Rarely used due to 
# assumption of constant growth rate and ROIC. 
Value = Year 1 NOPAT * 
        (1 - Growth / ROIC) /
        (WACC - Growth) 

# this is the same as the DCF model. Think of this as a 
# stacked bar graph where the starting invested capital 
# is the base, and the economic profit is the additional 
# value created on top of the base (which has decreasing 
# height due to time value of money).
Value = Starting Invested Capital +
        Present Value of (Projected Economic Profit) 

# this is the same as the DCF model. Think of this as the 
# present value of the future cash flows.
Value = FCF at t=1 / (WACC - Growth) 

# this represents growth rate of NOPAT
Growth = ROIC *
         Investment Rate 

# if you always reinvest at the same rate, your cash flow
# is always a constant percentage of earnings
Cash Flow = Earnings *
            (1 - Investment Rate) 

# this is the same as the previous equation
Cash Flow = Earnings * (1 - Growth / ROIC) 

# per year. If we project economic profit at the same rate,
# we get the same valuation as the DCF model (see above).
Economic Profit = Invested Capital * 
                  (ROIC - WACC)

Anything that doesn’t increase cash flows does not create value.

Chapter 4: Risk and the Cost of Capital

The cost of capital is not a cash cost, but an opportunity cost. It’s the return that investors could earn on an investment of equivalent risk.
Shrewd diversification in moderate amounts can help reduce risk without an equivalent decline in return.
Valuation using DCF can have its inputs manipulated to give a desired output. This is why it’s important to understand the assumptions behind the model and not just assume everything will go well. To combat this, develop multiple scenarios illustrating various potential future cash flows and calculate the expected value across all scenarios.
Managers tend to be risk-averse, and place greater weight on the potential downside of a decision than the potential upside. This is why they tend to overestimate the cost of capital and underestimate the value of growth opportunities.
Managers should choose the portfolio of projects that returns the highest expected value, but with one exception—if a project will bankrupt the company if it fails, it should not be undertaken, regardless of how high the probability of success is. In other words, avoid risks that threaten the company’s ability to operate normally.

Risk enters valuation both through the company’s cost of capital (an opportunity cost) and through the uncertainty surrounding future cash flows.

Chapter 5: The Alchemy of Stock Market Performance

Expectation Treadmill: Good execution by management in the past results in above average total shareholder returns (TSR) where high expectations of continued excellence are priced into the stock. In the future, even if the company continues to execute well and meets these high expectations, the stock price will not be as impressive as before (because it’s expected). A large driver of TSR is the change in the company’s growth potential instead of simply being a good company.

a company with low expectations of success among shareholders at the beginning of a period may have an easier time outperforming the stock market simply because low expectations are easier to beat.

Managers of companies that are vulnerable to the expectation treadmill may resort to misguided actions to continue the period of excellence to justify or accelerate the share price, such as pushing for unrealistic earnings growth or pursuing risky acquisitions that are not value-creating.
Therefore, TSR is driven by changes in expectation for the company and an improvement in the company’s growth potential. In order to analyse management performance well and determine the right metric by which to incentivise management, we need to dissect TSR beyond the standard textbook definition of TSR = Percent Change in Market Value + Dividend Yield.
Breakdown TSR into 5 components as follows:

TSR = Percent Change in Revenue -
      Investment / Market Value +
      Impact of Change in Profit Margin +
      Net Income / Market Value +  # aka earnings yield
      Percent Change in P/E

OR (substituting Investment / Mkt Val)

TSR = Percent Change in Revenue -
      1 / P/E * Growth / ROIC +
      Impact of Change in Profit Margin +
      Net Income / Market Value +  # aka earnings yield
      Percent Change in P/E

A company should therefore measure management performance in terms of company-specific performance aka growth, ROIC, TSR performance relative to peers (Growth - Investment / Mkt Val).
Financial leverage can artifically elevate TSR while masking the cost of debt and increased risk in the future. Managers incentivised purely by TSR may be tempted to increase financial leverage to boost TSR, but this may not be in the best interest of the company in the long run. (see page 79)
Managers can also expect their share price to decrease in the near term if they see, using the 5 components of TSR, that their TSR thus far is driven by investors’ increased expectations and thus issue less bullish guidance to their board and shareholders.
An incentive package that seeks to boost TSR over the period of 10-15 years (i.e., long term) has a good chance of aligning management with shareholders.
A company not expected to grow and that distributes 100% of their earnings (NOPAT) as dividends means that the inverse of their P/E ratio is their return of the company’s shares.