Valuation

Measuring and Managing the Value of Companies

Tim Koller, Marc Goedhart, David Wessels

• Publisher: Wiley
• Year: 2010
• ISBN:
  9780470893616
• Edition: 4
• Topic: Business
• Subtopic: Valuation
• Index: Business

The University Edition of Valuation 4e offers students and professors up-to-date information on valuing companies. It contains all the revisions of the main edition, plus end of chapter questions for the needs of the classroom.

Part One

Foundations of Value

1

Why Maximize Value?

Chief executives from North America to Europe and Asia may be forgiven if they appear perplexed as they try to figure out how to lead their companies following the tumultuous business evolution of the past decade. A 20-year bull market in equities that began in 1980 carried nearly every company on an upward spiral of wealth generation. Shareholders who reaped these rewards cheered CEOs even as executives built up lucrative stock option packages and in some cases attained rock-star celebrity status. By the time the Internet frenzy peaked at the end of the 1990s, even staunch traditionalists like Warren Buffett pondered whether the economy had entered a new era of prosperity unbounded by traditional constraints. Some economists took to questioning long-held tenets of competitive advantage, and “new economy” analysts asked, with the utmost seriousness, why a three-year-old-money-losing Internet purveyor of pet supplies shouldn’t be worth more than a billion dollars.

The subsequent market crash left aftershocks that have yet to be sorted out as we prepare this book. The Internet, source of the dot-com fever, continues to change the way we shop, communicate, and manage; but its assault on the fundamental laws of economics has been brusquely turned back. The sky-high market capitalizations of many Internet companies proved to be simply unsustainable, and their plunge has left a generation of chastened investors in search of a new approach. A flurry of major corporate accounting scandals turned hero CEOs into villains, spawned government investigations and new regulations, and unleashed a new spirit of shareholder activism whose impact on corporate governance has yet to fully play out. For their part, U.S. business groups have begun to challenge the authority of regulators to impose new rules.

Ironically, one thing that did not change was the stock market’s obsession with quarterly earnings. This focus continues to confront business leaders with the dilemma of often having to choose between short-term results and the long-term health of the companies they lead.

The good news? Amid this angst and uncertainty, executives and investors alike can draw reassurance from an important trend that has gained momentum even through years of the market’s twists and turns. More and more investors, analysts, and investment bankers are turning to fundamental financial analysis and sophisticated discounted cash flow (DCF) models as the touchstone of corporate valuation.

This book explains how to value companies using the DCF approach and apply that information to make wiser business and investment decisions. With DCF, assumptions about a company’s profits and cash flows years down the road determine a company’s stock price. Using it, CEOs can focus on long-term value creation, confident that their stock’s market price will eventually reflect their efforts. This is not a book for traders looking to profit from short-term movements in share prices. Nor is it intended for managers trying to manage their company’s share price from quarter to quarter. It’s purpose is to help managers looking to create lasting value in their companies.

Managers who focus on shareholder value create healthier companies, which in turn provide spillover benefits, such as stronger economies, higher living standards, and more employment opportunities. Our central message: Companies thrive when they create real economic value for their shareholders.

The movement underway to improve corporate governance will encourage companies to focus on long-term value creation. Managers and board members, therefore, should set long-term shareholder value creation as their primary objective. This book tells managers how, explaining specifically what it means to create sustainable value and how to measure value creation.

In the chapters that follow, we lay out the principles of value creation with examples and supporting empirical evidence. Companies create value by investing capital at rates of return that exceed their cost of capital. The more capital they can invest at attractive rates of return, the more value they will create, and as long as returns on capital exceed the cost of that capital, faster growth will create more value. Furthermore, value creation plans must always be grounded in realistic assessments of product market opportunities and the competitive environment. We also explore how value creation principles must be part of important decisions such as corporate strategy, mergers, acquisitions, divestitures, capital structure, and investor communications. We explain why value creation should be part of a company’s culture and how it manages itself on a day-to-day basis. And we provide detailed explanations for measuring value.

These fundamental principles have been around for a long time, and the events of the recent past have only strengthened our conviction in them. This may seem counterintuitive, since we learned during the recent past that financial markets may not have been as efficient as we thought they were. At times, the stock market may not be a reliable indicator of a company’s intrinsic value. Paradoxically, the fact that markets can deviate from intrinsic values means that managers have to be more attuned to the underlying value of their businesses and how their companies go about creating value, because they can’t always rely on signals from the stock market.

Specifically, managers must not only have a theoretical understanding of value creation, but must be able to create tangible links between their strategies and value creation. This means, for example, focusing less on recent financial performance and more on what they are doing to create a “healthy” company that can create value over the longer term. It means having a thorough grounding in the economics of an industry and setting aspirations accordingly. Once they’ve mastered the economics of value creation, they need to be able to educate their internal and external constituents. They need to install performance management systems that encourage real value creation, not merely short-term accounting results. Finally, they need to educate their investors about how and when the company will create value.

These principles apply equally to mature manufacturing companies and high-growth technology companies. They apply to companies in all geographies. When managers, boards of directors, and investors forget these simple truths, the consequences can be destructive. Consider the rise and fall of business conglomerates in the 1970s, hostile takeovers in the United States in the 1980s, the collapse of Japan’s bubble economy in the 1990s, the Southeast Asian crisis in 1998, the Internet bubble, and the corporate governance scandals of the late 1990s.

We begin this chapter by arguing that, from a long-term perspective, the stock market does indeed track the fundamental performance of companies and the economy. When deviations arise, they typically come from individual sectors and rarely last more than a couple of years. Deviations from fundamentals occur when companies, investors and bankers ignore the principles of economics or assume that they have changed.

MARKETS TRACK ECONOMIC FUNDAMENTALS

The U.S. stock market’s behavior from 1980 through today has confused and frustrated investors and managers. For roughly 20 of those years, the market was quite bullish as the Standard & Poor’s (S&P) 500 index rose from a level of 108 in January 1980 to 1,469 in December 1999. Including dividends, the nominal annual return to shareholders was 17 percent, or 13 percent after adjusting for inflation, more than double the 6½ percent average annual return that stocks have delivered over the past 100 years. By early 2000, many investors had come to expect consistently high returns from equity investing. Then the market abruptly fell, tumbling more than 30 percent over the next three years. Such a large run-up, followed by such a sharp decline, led many to question whether the stock market was anything more than a giant roulette table, essentially unconnected to the real world.

The stock market’s performance, however, can be explained. More important, the explanation derives directly from the real economy, in terms of inflation, interest rates, growth in gross domestic product, and corporate profits. This relationship may not be perfect, but research shows that deviations from what we call a company’s fundamental, or intrinsic, value based on financial performance and risk, tend to be short-lived and most often limited to certain industrial or service sectors.

The stock market’s real surprise lies, not in the occurrence of spectacular share price bubbles, but rather in how closely the market has mirrored economic fundamentals throughout a century of technological revolutions, monetary changes, political and economic crises, and wars. And it is not just true for the U.S. stock market. We believe stock markets in the United States, Europe, and Asia correctly reflect these regions’ different underlying economic prospects.

The Stock Market’s Long-Term Returns

U.S. equities over the past 200 years have on average returned about 6½ percent annually, adjusted for inflation. Spectacular market bubbles, crashes, or scandals occasionally captivate public attention, as they did during the recent high-tech market frenzy, the accounting scandals of the late 1990s, the Black Monday crash in October 1987, the leveraged-buyout craze of the 1980s, and of course the great Wall Street crash of 1929. But against the backdrop of decade after decade of consistent stock returns, the effect of any of these single events pales. At a minimum, as Exhibit 1.1 shows, stock markets are far from chaotic and do not lead a life of their own.

That 6½ percent long-term real return on common stocks is no random number either. Its origins lie in the fundamental performance of companies and the returns investors have expected for taking on the risk of investing in companies. One way to understand this linkage is to examine the economy’s underlying performance and its relationship to stocks. After adjusting for inflation, median price-to-earnings ratios (P/E) tend to revert to a normal level of about 15, suggesting that the typical investor’s risk-return trade-offs haven’t changed much over the past 100 years. Assuming that investor risk preferences have not changed, we can easily connect sharehol...