Beyond Earnings

Applying the HOLT CFROI and Economic Profit Framework

David A. Holland, Bryant A. Matthews

• Publisher: Wiley
• Year: 2017
• ISBN:
  9781119440529
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Valoración

Beyond Earnings is targeted at investors, financial professionals, and students who want to improve their ability to analyze financial statements, forecast cash flows, and ultimately value a company.The authors demonstrate that reported earnings are easily gamed by accounting shenanigans and reveal how commonly used profitability measures such as return on equity can be misleading.

Because earnings and P/E ratios are too unreliable for valuation, this book takes you beyond earnings and shows you how to apply the HOLT CFROI and Economic Profit framework in a step-by-step manner.A better measure of profitability results in improved capital allocation decisions and fundamental valuations.

This ground-breaking book offers the first practical in-depth discussion of how profitability and growth fade, and shows how to put this information to work right away. The authors introduce their trailblazing Fundamental Pricing Model which includes fade as an adjustable value driver and can be used to value the impact of business model disruption.

As the authors explain, the key to superior stock picking is understanding the expectations embedded in a stock's price and having a clear view of whether the company can beat those expectations. The HOLT framework has been rigorously field tested for over 40 years by global investment professionals to help them make better stock picks and by corporate managers to understand the expectations embedded in their stock price.

Beyond Earnings is an indispensable guide for investors who want to improve their odds of outperforming the competition.

Section II
Discounted Cash Flow and Economic Profit Valuation

4
WHAT’S IT WORTH? VALUING THE FIRM

“The value of any stock, bond, or business today is determined by the cash inflows and outflows—discounted at an appropriate interest rate—that can be expected to occur during the remaining life of the asset.”

—The Theory of Investment Value, John Burr Williams

KEY LEARNING POINTS

• We outline how to calculate and forecast free cash flow to the firm (FCFF), which is central to performing a discounted cash flow valuation.
• We show how to value the terminal period of a forecast. A fade factor can be easily incorporated, making it possible to test the sensitivity of a valuation to changes in the rate at which profitability decays.
• The calculation and utility of economic profit (EP) in assessing economic performance and valuing a firm is described. For a given forecast, discounted FCFF and EP valuations yield the same result. We value Air Liquide and demonstrate its sensitivity to profitability fade.
• We step through the calculation of FCFF in the HOLT framework, and show how it can be estimated from a CFROI and asset growth forecast.
• Different profitability and growth scenarios are valued for Amazon, indicating that it is expected to maintain high profitability and fast growth.
• Air Liquide is analyzed through the lens of the HOLT framework.

We have outlined how to calculate a firm’s CFROI and analyze its historical operating performance. The next step is to calculate its intrinsic value based on profitability, growth, and cash flow forecasts. We will explore different discounted cash flow (DCF) approaches in this chapter and then apply our knowledge and estimate the value of companies using both the HOLT and conventional DCF frameworks.

The goal of a DCF forecast is to estimate the intrinsic value of a company and its sensitivity to changes in key drivers. By intrinsic value, we mean the present value of the firm’s expected cash flows. Given the same forecast, we should obtain equivalent estimates of firm value from the various frameworks. But, as Yogi Berra quipped, “In theory, there is no difference between theory and practice. In practice, there is.” Differences most often arise in assumptions about a firm’s terminal value.

Let’s begin by reviewing the conventional discounted cash flow valuation approaches.

A REVIEW OF CONVENTIONAL VALUATION APPROACHES

The Entity Free Cash Flow Approach

The most popular method for valuing companies is to determine the present value of future free cash flows to the firm (FCFF). FCFF is the free cash flow to all capital providers. It does not distinguish between debt and equity. Projected free cash flows are discounted at the firm’s cost of capital r:

Although the formula assumes the discount rate is constant, it will vary over time just as bond spot rates vary. The riskiness of future cash flows relative to the market might change too, causing the discount rate to change. For example, a biotech start‐up will probab...