ROIC with goodwill

ROIC with goodwill measures the company’s ability to create value over and above pre- miums paid for acquisitions.

ROIC excluding goodwill measures the underlying operating performance of the company and its businesses and is used to compare performance against peers and to analyze trends. It is not distorted by the price premiums paid for acquisitions.

ROIC is a better analytical tool for understanding the company’s perfor- mance than return on equity (ROE) or return on assets (ROA) because

focuses solely on a company’s operations.

Return on equity mixes operating performance with capital structure, making peer group analysis and trend analysis less meaningful.

Return on assets (even when calculated on a preinterest basis) is an inadequate measure of performance because it includes non- operating assets + ignores the benefits of accounts payable and other operating liabilities that together reduce the amount of capital required from investors.

relation- ship between return on equity (ROE) and return on invested capital (ROIC):

ROE=ROIC+[ROIC−(1−T)k_{d}] D/E

raise its ROE, the company can either increase its ROIC (through operating improvements) or increase its debt-to-equity ratio (by swapping debt for equity). Although each strategy can lead to an identical change in ROE, increasing the debt-to-equity ratio makes the company’s ROE more sensitive to changes in operating per- formance (ROIC). Thus, while increasing the debt-to-equity ratio can increase ROE, it does so by increasing the risks faced by shareholders.

To assess leverage, measure

the company’s (market) debt-to-equity ratio over time and against peers. Does the leverage ratio compare favorably with the industry? How much risk is the company taking

payout ratio

If the company has a high dividend payout ratio and a reinvestment ratio greater than 1, then it must be borrowing money to fund negative free cash flow, to pay interest, or to pay dividends. But is this sustainable

A company with positive free cash flow and low dividend payout is probably paying down debt (or aggregating excess cash). In this situ- ation, is the company passing up the valuable tax benefits of debt or hoarding cash unnecessarily

Coverage

The company’s ability to meet short-term obligations is measured with ratios that incorporate three measures of earnings:

Earnings before interest, taxes, and amortization (EBITA).

Earnings before interest, taxes, depreciation, and amortization (EBITDA).

Earnings before interest, taxes, depreciation, amortization, and rental expense (EBITDAR).

develop an explicit forecast for a number of years and then to value the remaining years by using a perpetuity formula, such as the key value driver formula. Whatever perpetuity formula you choose, all the continuing-value approaches assume steady- state performance

the company grows at a constant rate by reinvesting a constant propor- tion of its operating profits into the business each year.

The company earns a constant rate of return on both existing capital and new capital invested.

free cash flow for a steady-state company will grow

at a constant rate and can be valued using a growth perpetuity. The explicit forecast period should be long enough that the company’s growth rate is less than or equal to that of the economy. Higher growth rates would eventually make companies unrealistically large relative to the aggregate economy.

In general, we recommend using an explicit forecast period of 10 to 15 years

Y

Using a short explicit forecast period, such as five years, typically results in a significant undervaluation of a company or requires heroic longterm growth assumptions in the continuing value

the difficulty of forecasting individual line items 10 to 15 years into the future.

The WACC represents

the opportunity cost that investors face for investing their funds in one particular business instead of others with similar risk.

cost of capital?

The return required by providers of capital

Acts as a “hurdle rate”:

- Rate at which cash flows can be discounted
- Return a company needs to exceed to create shareholder value

Weighted average cost of capital (WACC):

– Cost of capital under enterprise DCF method (as well as Economic

Profit valuation)

– Inclusion of tax shield on debt in WACC

– Represents the return required to satisfy all sources of capital

– Intimately linked with “invested capital”

The most important principle underlying successful implementation of the cost of capital is

onsistency between the components of the WACC and free cash flow.

To assure consistency among WACC and free cash flow. the cost of capital must meet the following criteria:

It must include the opportunity costs of all investors—debt, equity, and so on—since free cash flow is available to all investors, who expect compensation for the risks they take.

It must weight each security’s required return by its target market-based weight, not by its historical book value.

Any financing-related benefits or costs, such as interest tax shields, not included in free cash flow must be incorporated into the cost of capital or valued separately using adjusted present value.

It must be computed after corporate taxes (since free cash flow is calculated in after-tax terms).

It must be based on the same expectations of inflation as those embedded in forecasts of free cash flow.

The duration of the securities used to estimate the cost of capital must match the duration of the cash flows

Ideally, each cash flow should be discounted using a government bond with

he same maturity. For instance, a cash flow generated 10 years from today should be discounted by a cost of capital derived from a 10-year zero- coupon government bond

Method to estimate equity risk premium

- Historical (unconditional estimate, approximately 6%)

– Regression-based (i.e. conditional on variables such as dividend yield that forecast returns)

– Forward-looking (i.e. “implied” from current price and expected cash flows – compare current price to cash flow to solve for ERP)

Use the implied method. Why? to esimate equity risk premium

– Historical measures are probably distorted

– Implied method acknowledges that ERP varies through time

– Implied ERP supports valuation relative to market of the day

– Issues:

a) Cash flow assumptions – errors feed directly into ERP

estimates

b) Is market at fair value, i.e. is it priced for required returns?

Estimating the market risk premium with forward-looking models

A stock’s price equals the present value of its dividends.