公司治理结构与价值分析

CorporateGovernance

and

theValueofFirms

--SomeExperiencesofU.SandAsiaProfessorK.C.JohnWei,PhDTel:(852)-2358-7676;Fax:(852)-2358-1749E-mail:johnwei@ust.hkDepartmentofFinance,HKUSTandVisitingDepartmentofFinance,PekingUniversityPreparedforCCER,PekingUniversityNovember8,2003CFAII_SS18:OptionsHKUSTBusinessSchool1K.C.JohnWeiProfileofProf.K.C.JohnWeiProf.K.C.JohnWeireceivedhisPhDinFinanceattheUniversityofIllinois,Champaign-Urbana,in1984.HeservedtheUniversityofMississippiasanAssistantProfessorfromJanuary1984toJune1988.AfterservingtheUniversityofMiamiasanAssistantProfessorforoneyear,hemovedtoIndianaUniversity,whereheservedasanAssociatedProfessorfromJuly1989toJune1992.

SinceJuly1992,Prof.JohnWeihasbeenservingtheHKUSTBusinessSchoolinitiallyasanAssociateProfessorandlaterwaspromotedtofullProfessor.HeservedasActingHeadoftheDepartmentofFinancefromJanuary2001–August2002andFebruary–June2003.Prof.WeihasalsobeenappointedtheDirectoroftheCentreforAsianFinancialMarketssince1995.HewasvisitingUniversityofTexasatAustinfromSeptembertoDecember2002andiscurrentlyvisitingGuanghauSchoolofManagement,PekingUniversity.Withresearchfocusesonempiricalresearchincapitalmarkets,derivativesandassetpricingofAsianandU.S.markets,Prof.Weihasproducedanumberofhighqualitypapersontheseareas.Manyofthesepaperswerepublishedintopjournalsinfinanceandhavemadeconsiderablecontributionstothefinanceliterature.Heisanauthoroffourbooks(inChinese)onHongKongstockandwarrantsmarketsandTaiwanesestockmarket.Inaddition,Prof.WeiisaregularcolumnwriterfortheHongKongEconomicJournal,alocalnewspaperspecialisedinfinancialnews.Ontheconsultancyactivities,Prof.WeihashelpedHangSengBanktodevelopapersonalfinancialplanningmodelcalled“SmartInvest,”andHSBCtodevelopafinancialplanningmodel,called“Rule-BasedInvestmentSolutions.”HealsoconductedaconsultancyprojectinitiatedbyHKSARforAPECandafewprojectsforHongKongStockExchange.

Prof.WeihavebeeninvolvedexecutiveteachingforHKUST,PekingUniversity,HongKongStockExchange,Chineseprovincialgovernmentofficials,generalcorporateexecutives,XieanJassen,Daimler/Chrysler,ChinaMobile,Aspire,andBenQ.CFAII_SS18:OptionsHKUSTBusinessSchool2K.C.JohnWeiValuecreationandbusinessstrategiesValuationCreationQijiaCEOXiushenZhiguoPingtianxiaManagementteamAssetsinplaceGrowthopportunityCapitalPeopleManagementskillsVisionIntegrityCorporategovernanceIncentivesRestructuringCompetitiveadvantagesM&A(external)Investment(internal)(ROIC>WACC)R&DEquityDebtCentralbankCommercialbanksInvestmentbanksMutualfundsInsurancecompaniesValuationmethodsDCFComparativemeasureROAInvestorsTimingCostofcapital(WACC)FinancialengineeringCBCapitalmarketsObjective/StrategyInvestorbehaviorGreedandfearCognitiveorheuristicbiasFocusvsDiversified(CiscovsGE)OEMvsBrandLowvshighendCFAII_SS18:OptionsHKUSTBusinessSchool3K.C.JohnWeiValuecreationviafinancialstrategiesDividendpolicy:ReinvestmentShareholdervalueInvestmentdecision:GrowthoptionsFinancingdecision:WACCCorporategovernance:AsymmetricinformationApproachestovaluationMergers&AcquisitionsValuecreationROIC>WACCDCF(NPV)valuationComparablevaluationROARestructuring(Strategy)Whyvaluevalue?ManagementdisciplineTransparencyIndependenceAccountabilityResponsibilityFairnessSocialresponsibilityStrategiestocreatevalueInternalgrowthWhatisyourdreamcompany?FocusvsdiversifiedCorecompetence

CFAII_SS18:OptionsHKUSTBusinessSchool4K.C.JohnWeiHowtovalueafirmThevalueofafirmwithaconstantgrowrateis whereNOPLAT=netoperatingprofitlessadjustedtaxes EBIT=earningsbeforeinterestandtaxes t=averagetaxrate WACC=weighedaveragecostofcapital g=growthrate=reinvestmentrate×ROIC ROIC=returnonnewinvestedcapital=NOPLAT/IC g/ROIC=reinvestmentrate=rICFAII_SS18:OptionsHKUSTBusinessSchool5K.C.JohnWeiHowtoenhancethevalueofafirmTheMMformulaHowtoenhancethevalueofafirmIncreaseoperatingefficiency(NOPLAT)Increasereturnonnewinvestedcapital(ROIC)InvestinnewprojectonlywhenROIC>WACCIncreasethegrowth(g),rI=g/ROICProlongtheperiodofcompetitiveadvantage(N)Reducethecostofcapital(WACC)CFAII_SS18:OptionsHKUSTBusinessSchool6K.C.JohnWeiValueDriversThreevaluedrivers:Abnormalprofit(investonlywhenROIC>WACC):intherightindustryGrowth(g)orreinvestment:inthehighgrowthindustryRisk(WACC):(1)economy-widerisk(businesscycle),(2)operatingrisk(degreeofcapitalintensity),and(3)financingrisk(leverage)Commonmistake:Managersoftenignorethecostof“equity”capitalCFAII_SS18:OptionsHKUSTBusinessSchool7K.C.JohnWeiSourcesofabnormalprofitMonopoly(Highprofitmargin):MicrosoftoreBay(priceorservicedifferential;intherightindustry)Lowcostoperator:HonHaiPrecision,TaiwanSemiconductor,Dell,BYD(makemoneyfromgoodmanagement)Lowfinancingcost:GEBarriertoentry:(1)capital,(2)technology(patents),(3)distributionchannels,(4)governmentprotectionExample:Profitmargin=20%;WACC=15%;Capitalturnover=2timesForevery$100sales,profit=$20,requiredcapitalinvestment=$50,costofcapital=$50*15%=$7.50,abnormalprofit=$20–$7.5=$12.5.Atwhatlevelofprofitmargin,willthefirmbecomeamaturecompany?CFAII_SS18:OptionsHKUSTBusinessSchool8K.C.JohnWeiAbnormalprofit:Motorola,EricssonandNokia1993-19951994-961995-971996-98MotorolaROIC20.26%16.83%14.14%8.17%WACC8.21%13.00%14.01%14.11%Diff12.05%3.84%0.12%-5.94%EricssonROIC27.25%28.54%32.73%20.60%WACC5.07%8.10%11.80%11.69%Diff22.18%20.44%20.92%8.90%NokiaROIC11.94%15.42%18.71%27.60%WACC6.56%8.80%8.32%9.07%Diff5.39%6.62%10.39%18.54%CFAII_SS18:OptionsHKUSTBusinessSchool9K.C.JohnWeiEarningsqualityAreyourcompanyfutureincomeseasytoforecast?Aretheysensitivetobusinessorindustrycycle?(MicrosoftvsIntel;GMvsCocaCola)Economy-widerisk:Businesscycle(GMvsMerck)Operatingrisk:Levelofcapitalintensity(TSMCvsYuYuan)Financingrisk:Leverage(NWDvsSHKProperties)Accountinginformationrisk:Disclosureandcorporategovernance(CASvsIAS;TSMCvsUMC)InventoryAccountsreceivablesGrossmarginS&AexpensesReserveforbadaccountsreceivablesR&DProductivityCFAII_SS18:OptionsHKUSTBusinessSchool10K.C.JohnWeiCorporateGovernanceCFAII_SS18:OptionsHKUSTBusinessSchool11K.C.JohnWeiRecentcorporategovernanceproblemsintheU.S.ManipulationsofaccountingearningsEnron,GlobalCrossing,Xerox,AdelphiaCommunications,WorldCom,TycoInternational,ImCloneSystems,ArthurAnderson,FreddieMac,MicrosoftOff-BalanceSheetborrowingsEnron,ElanMotivation:Smoothearnings,jackupstockprices(stockoptions)ConsequencesFirmsinvolvedwenttobankruptcyorwereintroubleWholemarketdroppedduetoinvestors’lossofconfidenceRemediesStrengthentheregulationsbySECandtheU.S.CongressInternalandexternalauditingMoreefficientboardsofdirectorsCFAII_SS18:OptionsHKUSTBusinessSchool12K.C.JohnWeiCharacteristicsofAsianCompaniesOwnedandcontrolledbyfamily(pyramidorcrossholding)Enhancement(interestsofmanagersandshareholderscanbemorealigned)Entrenchment(stealing,tunneling,ignoringordestroyingfirmvalue)Lackofcorporategovernance(TSMCCEO:Integrity)CannottrustoutsideprofessionalmanagersDon’tknowhowtodelegatePassCEOpositiontoownsonratherthancapablemanagerCommittomorecognitiveorheuristicbiasCFAII_SS18:OptionsHKUSTBusinessSchool13K.C.JohnWeiWhyiscorporategovernanceimportant?ArecentsurveyconductedbyMcKinsey&Co.showsinvestorspayapremiumofmorethan

20%forgoodCGfirms.Thebenefitsofgoodcorporategovernance:reducethecostofcapital(WACC)increasethevalueofthefirmsbenefitshareholders,employees,andsocietyChen,Chen,andWei(2003)findcompaniesinEastAsia:non-disclosureCGimprovesfrombottom25%totop75%:thecostofequitycapitalisreduced1.26%pointsDisclosureimprovesbythesamemagnitude,thecostofequitycapitalisreducedby0.47%pointFirmsinbetterCGcountrycanalsoreducethecostofcapitalSimons(HBR,September2002)profitabilityispositivelycorrelatedwithhowworkersperceivetheirmanagers'behavioralintegrity(hotelindustry)CFAII_SS18:OptionsHKUSTBusinessSchool14K.C.JohnWeiWhatiscorporategovernance?ThemechanismsofPushingfirmstooperatemoreefficientlyandtocreatevalue,andPreventingpotentialexploitationofoutsideinvestors,particularlyshareholders,bycorporateinsiderssuchasthemanagementShareholdershavecontrolrightsDirectorsandmanagersaresupposedtorunthefirmsintheinterestsoftheshareholders

CFAII_SS18:OptionsHKUSTBusinessSchool15K.C.JohnWeiWhyisitneeded?Agencyproblembetweenshareholdersandmanagers(problemforU.S.companies)Agencyproblembetweenmajorityshareholdersandminorityshareholders(problemforAsiancompanies)Expropriation(entrenchment,stealing,tunneling)CFAII_SS18:OptionsHKUSTBusinessSchool16K.C.JohnWeiGoodgovernancepracticeWhatmakesgreatboardsgreat(SonnenfeldHBR,September2002)verysimply,high-functioningworkgroupsaclimateofrespect,trust,andcandoramongboardmembersandbetweentheboardandmanagement.Informationissharedopenlyandontimefeelfreetochallengeoneanother’sassumptionsandconclusionsmanagementencourageslivelydiscussionofstrategicissues.feelresponsibilitytocontributetoperformance.assesstheirownperformance,bothcollectivelyandindividually.InstallingeffectivelyindependentboardAnindependentboardchairman(CEOnotthechairman)ThreemostindependentcommitteesonanyboardTheauditcommitteeThecompensationcommitteeThenominatingcommitteeCFAII_SS18:OptionsHKUSTBusinessSchool17K.C.JohnWeiWhyValueValue?CFAII_SS18:OptionsHKUSTBusinessSchool18K.C.JohnWeiJapaninMid-1980s:WeareNumberOneFromKimandYoungCFAII_SS18:OptionsHKUSTBusinessSchool19K.C.JohnWeiJapanNow:WeareinProlongRecessionFinancialTimes:February2,2002CFAII_SS18:OptionsHKUSTBusinessSchool20K.C.JohnWeiNikkei225vs.Dow:January1984-June2003

CFAII_SS18:OptionsHKUSTBusinessSchool21K.C.JohnWeiNotEveryThingisEqual:SonyisDifferent

CFAII_SS18:OptionsHKUSTBusinessSchool22K.C.JohnWeiToyotaMotorisalsoDifferent

CFAII_SS18:OptionsHKUSTBusinessSchool23K.C.JohnWeiButNissanisthesameuntilRecentlyCFAII_SS18:OptionsHKUSTBusinessSchool24K.C.JohnWeiRenault’s44.4%purchaseinMarch1999

makesNissandifferentsince

CFAII_SS18:OptionsHKUSTBusinessSchool25K.C.JohnWeiValue-BasedManagementMakestheDifferencesTheperformancedifferencebetweenU.S.firmsandJapanesefirms,andbetweenSonyandotherJapanesefirmsisGoodperformersadoptValue-BasedManagement(VBM),whilelosersdonot.WhatistheproblemfortheU.S.marketnow?WhatisVBM?VBMfocusesonvaluecreationfortheirshareholders

ratherthanstakeholdersCFAII_SS18:OptionsHKUSTBusinessSchool26K.C.JohnWeiWhatistheDecisionRuleforVBM?VBMfocusesoninvestments(oldornew)thatcangenerateareturnoninvestedcapitalgreaterthantheircostofcapital.Thatis,investonlywhen

ROIC>WACC

CFAII_SS18:OptionsHKUSTBusinessSchool27K.C.JohnWeiWhatistheValueofaFirm?Firmvalue=Valueofequity+ValueofdebtFirmValue=Assetsinplace+Growthopportunities =Bookvalue+GrowthoptionsGrowthoptionmakesamajordifferenceinvalueamongfirmsCFAII_SS18:OptionsHKUSTBusinessSchool28K.C.JohnWeiShareholder-OrientedEconomiesPerformBetterTheU.S.corporatefocusonshareholdervaluesincethemid-1980.Thebenefitsare:GDPpercapitaintheU.S.hasaleadofmorethan20%overothercountriesandhasbeenwideningsinceearly1990s,duetoMuchhigherfactorproductivity,especiallycapitalproductivityInvestedinmoreproductive(orvaluecreating)projects,i.e.,higherfinancialreturnsCFAII_SS18:OptionsHKUSTBusinessSchool29K.C.JohnWeiShareholder-OrientedFirmsBenefitAll200yearsago,AdamSmithpostulatedthat “themostproductiveandinnovativecompanieswouldcreatethehighestreturnstoshareholdersandattractbetterworkers,whowouldbemoreproductiveandincreasereturnsfurther”–avirtuouscycle Ontheotherhand,“Companiesthatdestroyvaluewouldcreateaviciouscycleandeventuallywitheraway”CFAII_SS18:OptionsHKUSTBusinessSchool30K.C.JohnWeiShareholder-OrientedFirmsBenefitAll(con’t)CompanieswithhigherlaborproductivityaremorelikelytocreatemorevalueCompaniesthatareabletocreatemorevaluealsocreatemorejobsHappyworkers,happyinvestors(Fortune,May2002)Conclusion:

AshareholdervaluefocusnotonlyisgoodforshareholdersbutalsogoodfortheeconomyandotherstakeholdersCFAII_SS18:OptionsHKUSTBusinessSchool31K.C.JohnWeiCasestudies(HBR)LeadingforvaluebyPitman(March2003):BritishbankLloydsTSBACEO-ledtransformationofthecompany'sculturebySirBrianPitman:value-basedmanagementasingledefinitionofsuccessandasinglemeansofmeasuringit.AtLloyds,hereplacedtheexistingarrayofimplicitobjectiveswithasinglegoverningobjective(generategreatervalueforshareholders)andestablishedincreasinglysophisticatedinternalmetricsforachievingit.createvalueforeveryone:Customer,employees,andcommunities.From1983to2001,BritishbankLloydsTSBincreaseditsmarketcapitalization40-fold,inpartbysheddingassetsandnarrowingitsfocus.CFAII_SS18:OptionsHKUSTBusinessSchool32K.C.JohnWeiCasestudies(HBR)WhencompanyvaluesbackfirebyEdmondsonandCha(2002-11)MaymisinterpretandbrandtheCEOasahypocriteMakeyourvaluesmeansomethingbyLencioni(2002-07)Enron2000annualreportforcorporatevalue:“Communication.Respect.Integrity.Excellence.”Emptyvaluesstatementscreatecynicalanddispiritedemployeesandunderminemanagerialcredibility

Valuesstatementsreallytomeansomethingshouldfollow:understandthedifferenttypesofvalues:core,aspirational,permission-to-play,andaccidental.beaggressivelyauthenticowntheprocessweavecorevaluesintoeverythingCFAII_SS18:OptionsHKUSTBusinessSchool33K.C.JohnWeiRestructuringCompaniesGeneralCFAII_SS18:OptionsHKUSTBusinessSchool34K.C.JohnWeiTheValueManagerAfocusonlong-runcashflowreturns,notquarter-to-quarterchangesinearningspershareValue-orientedview:Investonlywhenreturnoninvestedcapital>costofcapital(ROIC>WACC)Abilitytotakeanoutsider’sviewofthebusinessWillingnesstoactonopportunitiestocreateincrementalvalueFinally,andthemostimportant,theneedtodevelopandinstitutionalizeamanagingvaluephilosophythroughouttheorganization(itisanongoinginitiative)CFAII_SS18:OptionsHKUSTBusinessSchool35K.C.JohnWeiTheProcessofBecomingValue-OrientedArestructuringthatunleashesvaluetrappedwithinthecompany(highbenefit;butthecostcanbehigh)DivesturesLayoffsDevelopingavalue-orientedapproachtoleadingandmanagingtheircompaniesafterrestructuringEstablishingprioritiesbasedonvaluecreationGearingplanning,performancemeasurement,andincentivecompensationsystemstowardshareholdervalueCommunicatingwithinvestorsintermsofvaluecreationCFAII_SS18:OptionsHKUSTBusinessSchool36K.C.JohnWeiWhenareCompaniesinNeedofRestructuring?Scoreof6-24with24beingtheworst(basedonMonitor)Totalreturntoshareholders(TRS)Salesgrowthrelativetoindustry(growth)Operatingmarginrelativetoindustry(operatingefficiency)Capitalreturnrelativetoindustry(ROIC)Numberofbusinessunits(focus?)Distancefrommedianindustrycapitalstructure(WACC,optimalcapitalstructure)CFAII_SS18:OptionsHKUSTBusinessSchool37K.C.JohnWeiRestructuringProcessDiagnosticScan(Decisiontorestructure)Restructuring(Implementationplan)Value-basedManagement(VBMimplemented)IncentiveDesign(Newincentivesystem)CFAII_SS18:OptionsHKUSTBusinessSchool38K.C.JohnWeiRestructuringFrameworkCurrentmarketvalueTotalpotentialvalueDCFvalueusinganalystforecastsValuewithinternalandexternalimprovementsDCFvalueusingmanagementexpectationValuewithinternalimprovementsMarketInefficiencyTakeoverspeculationInternalimprovementsCorporategovernanceOptimalopportunityPublicheldbusinessGrowthopportunities+FinancialEngineeringCapitalstructureDividendpolicyRiskmanagementDisposal/newownersM&AJointventureSpin-offsIPOsLetterstockDivestureOperatingimprovementsRevenuegrowthCostreductionCapitalefficiencyPerceptionGapOvervaluedUndervaluedValuecreatedThroughRestructuringCFAII_SS18:OptionsHKUSTBusinessSchool39K.C.JohnWeiRestructuringFramework:ExampleThiscompanyhad10businessunitsanditsstockpricewasdecliningMarketValue$1,000MaximumValuePotential$1,800DCFvalueusinganalystforecasts$1,050Valuewithinternalandexternalimprovements$1,650DCFvalueusingmanagementexpectation$950Valuewithinternalimprovement$1,200MarketInefficiency$50Valuecreated$800Growthopportunities+FinancialEngineering$150NotenoughdebtInternalimprovements$450Sold3losersInternalimprovements$250ExitunprofitableproductlinesReduceinventoryPerceptionGap-$100OvervaluedValuecreatedThroughRestructuringCFAII_SS18:OptionsHKUSTBusinessSchool40K.C.JohnWeiImproveOperations:InternalImprovementsChallengeeverypartofthebusinesssystemProcurementRawmaterialsManufacturing/Work-in-progressFinishedgoods(aretheycompetitive?)InventoryDistributionchannelandsalesAccountsreceivableCFAII_SS18:OptionsHKUSTBusinessSchool41K.C.JohnWeiRethinkyourportfolioofbusinesses:ExternalImprovementsFocusontwodimensionstolookforvalueimprovementValuecreationpotentialCompetitiveadvantageDecision:Highvaluecreation+bestincompetitiveadvantage:shouldgrowHighvaluecreation+weakincompetitiveadvantage:shouldimproveLowvaluecreationbusinesses:shoulddisposeCFAII_SS18:OptionsHKUSTBusinessSchool42K.C.JohnWeiOwnershipAlternatives:ExternalImprovementsSpin-offsAvoidcrosssubsidization(IBM/PC)Eliminatemanagementconstraints(ATT&Lucent)TaxfreeAnnouncementeffectispositive(mayexceedvalueofentitytobespunoff)InitialPublicOfferingsAllowdirectinvestmentinasubsidiaryTaxfreeifIPOkeepscash(whichmaybeusedtorepaycorporatedebt)Allowconsolidation(taxandaccounting)iflessthan20%ofequityissoldDirectSalesTaxable(mayprovidetaxshield)CFAII_SS18:OptionsHKUSTBusinessSchool43K.C.JohnWeiFinancialEngineeringMinimizingWeightedAverageCostofCapitalDoesNotMaximizeValueofFirm(Bankruptcycost)CostofequityWACCAfter-taxcostofdebtMinimumWACCMaximizeValueDebt/EquityPercentCFAII_SS18:OptionsHKUSTBusinessSchool44K.C.JohnWeiSourcesofRestructuringValueIntheU.S.,theaveragebreakdownofsourcesofvaluecreationfromrestructuringindicatesthatapproximately60%comesfromstrategicandoperatingimprovementsInternalImprovements60%DivestureorAcquisition25%FinancialEngineering15%CFAII_SS18:OptionsHKUSTBusinessSchool45K.C.JohnWeiPuttheValueCreationPlanintoActionPutValueintoPlanningFocusplanningandbusinessperformancereviewsaroundvaluecreationDevelopValue-OrientedTargetsandPerformanceMeasuresFocusonameasurethatincorporatebothgrowthandreturnoninvestedcapital(ROIC)

EP(Economicprofit)=Investedcapital×(ROIC–Opportunitycostofcapital)TieCompensationtoValueAssessValueofStrategicInvestmentsDevelopInvestorCommunicationsStrategyReshapetheCFO’sRoleCFAII_SS18:OptionsHKUSTBusinessSchool46K.C.JohnWeiSummaryforRestructuringManagingvalueconsistsofthreebroadsteps:Takingstockofthevalue-creationsituationwithinthecompanyandidentifyingrestructuringopportunitiesActingonthoseopportunities(operationalefficiencyimprovements,divestures,acquisitions,reorganization)Instillingavalue-creationphilosophyAmanaging-valuefocusdoesnotcreatevaluethroughfinancialmanipulations.ItcreatesvaluethroughdevelopingsoundstrategicandoperatingplansMostcompanieswouldbenefitfromathroughreviewofrestructuringopportunitiesManagersneedtoensurethattheyidentifyandactonvalue-creationopportunitiesregularlyCFAII_SS18:OptionsHKUSTBusinessSchool47K.C.JohnWeiApproachestoValuationDiscountCashFlow(DCF)valuationComparativemeasuresorrelativevaluationRealOptionsAnalysis(ROA)valuationCFAII_SS18:OptionsHKUSTBusinessSchool48K.C.JohnWeiDiscountedCashFlow(DCF)ValuationEstimatingFreeCashFlowCFAII_SS18:OptionsHKUSTBusinessSchool49K.C.JohnWeiMeasuringValueF1FirmCashflowsInvestedCapitalFixedAssetsOperatingWorkingCapitalYear1Year2Year3Year4Year5CFAII_SS18:OptionsHKUSTBusinessSchool50K.C.JohnWeiDiscountedCashFlowModelValueofoperations=Discountedvalueofexpectedfuturefreecashflow(FCF)CashflowsTimingRiskCFAII_SS18:OptionsHKUSTBusinessSchool51K.C.JohnWeiFreeCashFlow-DefinitionFreecashflowsare:after-taxcashflowfromoperationsremainingafterallre-investmentneedshavebeenmet.availablefordistributiontoallprovidersofcapital(bothshareholdersandbondholders).CFAII_SS18:OptionsHKUSTBusinessSchool52K.C.JohnWeiDCFValuation012T

TerminalValueT=FCFT+1/(WACC-g)FCF1FCF2…FCFT-1FCFT

T-1FCF=FreecashflowWACC=WeightedAverageCostofCapitalTV=TerminalValue(attimeT)=FCFT+1/(WACC–g),wheregisthelong-termgrowthrateinsalesT=Lengthoftheforecasthorizon(typically,7to10years)CFAII_SS18:OptionsHKUSTBusinessSchool53K.C.JohnWeiSensitivityanalysisExaminesensitivityofvaluationstodifferentassumptionsabout:Salesgrowth(affectsFCF)Profitmarginsoroperatingefficiencyoroperatingcost(affectsFCF)Assetturnoverratios(I.e.,capitalexpenditureorworkingcapitalinvestment)(affectFCF)WeightedaveragecostofcapitalCFAII_SS18:OptionsHKUSTBusinessSchool54K.C.JohnWeiFundamentalDriversofaCompany’sValueValueDriversCFAII_SS18:OptionsHKUSTBusinessSchool55K.C.JohnWeiBasicsofValueCreationAfirmcreatesvalueonlyifitearnsareturnonitsinvestedcapitalthatishigherthanthecostoffinancingtheinvestment.Thatis,ROIC>WACCThreevaluedrivers:GrowthAbnormalreturn(ROIC>WACC)WACC(risk)CFAII_SS18:OptionsHKUSTBusinessSchool56K.C.JohnWeiValueCreationAssetsInvestedCapital$100millionAfter-taxoperatingprofit(NOPLAT)$18millionReturnonInvestedCapital18%Debt$50millionEquity$50millionCostofDebt(after-tax)6%CostofEquity16%InvestedCapital$100millionWeightedAverageCostofCapital11%CFAII_SS18:OptionsHKUSTBusinessSchool57K.C.JohnWeiTheReturnSpreadReturnSpread= ReturnonInvestedCapital(ROIC) –WeightedAverageCostofCapital(WACC)WhenROIC>WACC,thefirmcreatesvalue.WhenROIC=WACC,thefirmneithercreatesvalue,nordestroysvalue.WhenROIC<WACC,thefirmdestroysvalue.EconomicProfitorEVA

=(ROIC–WACC)InvestedCapitalCFAII_SS18:OptionsHKUSTBusinessSchool58K.C.JohnWeiValueMetricsEPS(Earningspershare)ProfitMargin(ReturnonSales)Book-to-Market(B/M)Price-Earningsratio(P/E)ROIC(ReturnonInvestedCapital)EconomicProfitorEVA(EconomicValueAdded)DCF(DiscountedCashFlow)CFROI(CashFlowReturnonInvestment)TRS(TotalReturntoShareholders)…CFAII_SS18:OptionsHKUSTBusinessSchool59K.C.JohnWeiValueDriverAnalysisEconomicProfit=

(ROIC-WACC)InvestedCapitalValuedrivers:Abnormalreturn:InvestonlywhenROIC>WACCGrowth:gRisk:WACCCFAII_SS18:OptionsHKUSTBusinessSchool60K.C.JohnWeiROICTreeROICEBIT/InvestedCapitalCashTaxRateEBIT/SalesSales/InvestedCapitalOperatingWorkingCapital/SalesNetPPE/SalesOtherAssets/SalesCOGS/SalesDepreciation/SalesSGAExpenses/SalesROIC=ProfitmarginxAssetTurnoverValueGrowthROICWACCCFAII_SS18:OptionsHKUSTBusinessSchool61K.C.JohnWeiMergersandAcquisitionsCFAII_SS18:OptionsHKUSTBusinessSchool62K.C.JohnWeiIdentifyingValueCreationPossibilitiesWhatmakestwofirmsworthmoretogetherthanapart?Synergy(relatedness,economiesofscaleandscope):Gillette’sacquisitionof-DuracellEconomiesofverticalintegration(mergerofcompaniesatdifferentstagesofproduction):Time’sacquisitionofWarnerBrothersComplementaryresources(Thetargetmayhaveauniqueproductbutlacktheengineeringandsalesorganizationtoproduceandmarketitonalargescale.)Quickerandcheapertomergewithafirmthatalreadyhasalotoftalentthantodevelopengineeringandsalestalentfromscratch.CFAII_SS18:OptionsHKUSTBusinessSchool63K.C.JohnWeiEvidenceonValueCreationinM&ATransactionsThecombinedvalueofcompaniesengagedinmergersandtenderoffersincreasesbyabout7percentaroundtakeoverannouncements.Howisthevalueshared?Targetsgetthebulkofit.Acquirersgetroughlyzero.CFAII_SS18:OptionsHKUSTBusinessSchool64K.C.JohnWeiReasonsForFailuresOveroptimisticappraisalofmarketpotential:skepticalaboutReboundfromacyclicalslumpTurnaroundRapidgrowthc