Book: Key Concepts in Company Valuation

Review of Key Concepts in Company Valuation (McKinsey)

Subject: Overview of core valuation principles, methodologies, and practical considerations

I. Core Valuation Methodologies

• Discounted Cash Flow (DCF): The source emphasizes DCF as the most accurate and flexible method for valuing companies. The fundamental principle is to discount projected future cash flows to their present value. The total value is derived from the sum of discounted cash flows over an explicit forecast period and a continuing value.
• Free Cash Flow (FCF): DCF typically involves discounting free cash flow (FCF).
• Economic Profit (EP): Alternatively, a company can be valued by "discounting its projected economic profit at the cost of capital and adding the starting invested capital." The present value of economic profit for a growing perpetuity is calculated as "economic profit in year 1 divided by the cost of capital minus the growth rate."
• Capital Cash Flow (CCF): This method combines FCF and interest tax shields, discounting the combined flow at the same cost of capital (matching the WACC assumptions). The source states that "the capital cash flow and WACC-based valuations will lead to identical results."
• Tax Shields: The treatment of interest tax shields distinguishes the WACC, APV (Adjusted Present Value), and CCF methods. WACC incorporates the tax shield in the cost of capital, APV values it separately, and CCF includes it in the cash flow.
• Multiples: Using multiples (relative valuation) can provide insights and serve as a "great check on your DCF valuation if done properly." However, they are "often used in a superficial way that leads to erroneous conclusions." Proper use involves using forward earnings estimates, adjusting for nonoperating items, and using the "Right Peer Group" with similar economics.
• Types of Multiples: Commonly used multiples include earnings multiples (e.g., Net Enterprise Value divided by Adjusted EBITA or NOPAT), Revenue multiples, and multiples based on operating metrics (e.g., value per barrel of oil reserves, value per paying user/subscriber).
• Limitations of Operating Metrics Multiples: Effective use requires the metric to be a "reasonable predictor of future value creation and thus somehow tied to ROIC and growth." Simply averaging multiples from "apparently similar businesses provides little, if any, insight" if the underlying business models and economics differ significantly (as illustrated by the Netflix, Spotify, and Sirius XM example).

II. Key Value Drivers and Performance Analysis

• Return on Invested Capital (ROIC) and Growth: The source highlights ROIC and organic revenue growth as primary drivers of value. Analyzing historical financial performance involves focusing on "the operating performance of the company and its ability to create value."
• Economic Profit as a Measure: Economic profit captures both ROIC and growth.
• Detailed Revenue Forecasting: Revenue forecasts can be built using "top-down" (total market size, market share, pricing) or "bottom-up" (customer demand projections, customer turnover, new customers) approaches. Using both methods can help "establish bounds for the forecast." A "fine-grained look at a company’s sources of growth will make clear what drives the company’s valuation."
• Value Driver Trees: These tools can provide "additional insight into what has been driving same-store sales for each company," breaking down performance into contributing factors (e.g., transactions per store, revenues per transaction).
• Short-, Medium-, and Long-Term Value Drivers: To safeguard long-term health, companies should identify and set targets for various value drivers across different time horizons:
• Short-term: Immediate drivers of ROIC and growth (e.g., sales volume, cost per unit, transaction volume).
• Medium-term: Performance of existing products/services in existing markets (e.g., customer acquisition and retention, price setting, innovation).
• Long-term: Broader strategic choices and capabilities (e.g., new product development, entering new markets, building distinctive capabilities).

III. Capital Structure and Financing Considerations

• Financing Operations: The analysis of historical performance includes focusing on "how the company has financed its operations," examining the proportion of debt versus equity.
• Sustainability and Risk: Key questions include whether the capital structure is sustainable and if the company can survive downturns.
• Liquidity Measures: Coverage ratios (using EBITA and EBITDA) are used to "estimate the company’s ability to meet short-term obligations."
• Leverage Assessment: This involves measuring the company’s (market) debt-to-equity ratio over time and against peers to assess risk.
• Payout Ratio: Analyzing the dividend payout ratio provides insight into the company's financial situation in relation to its cash flow reinvestment.
• Cost of Capital: The cost of capital, particularly the weighted average cost of capital (WACC), is crucial for discounting cash flows.
• Risk-Free Rate: This is typically based on "the ten-year U.S. government bond yield" or inflation-linked bonds (ILBs) to estimate the real interest rate.
• Beta: Estimating a company's beta, a measure of systematic risk, is a key step. This involves estimating beta for peers, converting to "unlevered beta" (beta without debt), and examining the sample for a representative beta (preferably the median).
• Capital Structure Impact on Beta: "As leverage rises, so will the company’s equity beta." Unlevered betas focus on operating risk and can be averaged across industries with similar characteristics.
• Valuing Debt: Ideally, debt is valued at observable market value or by discounting promised cash flows at the appropriate yield to maturity. If market value is not available, book value can be used, but this may be inaccurate if interest rates or credit risk have changed significantly.
• Management's Financing Philosophy: Understanding management's approach to debt and cash deployment is important.

IV. Portfolio Management and Transactions

• Strategic Choices and Portfolio Strategy: Valuation is used to "Decide among alternative business strategies by estimating the value of each strategic choice" and "Develop a corporate portfolio strategy, based on understanding which business units a corporate parent is best positioned to own."
• Assessing Major Transactions: Valuation is critical for "Assess major transactions, including acquisitions, divestitures, and restructurings."
• "Better Owner" Principle: The source highlights the concept of a "better owner" as a key driver of value creation in M&A. This involves identifying synergies in areas like manufacturing, distribution, and marketing (as illustrated by the General Mills acquisition of Pillsbury). Distinctive skills and management approaches (like Danaher's Business System) can also make a company a better owner.
• Portfolio Evolution: Business portfolios evolve, and companies may "divest or spin off some of the businesses that were large enough to stand on their own." "Thoughtful shrinking" can allow disparate businesses to focus on their unique needs.
• Divestiture Considerations: Factors influencing divestiture decisions include market valuation levels, balancing potential proceeds against the "hidden costs of continuing with the status quo," and exploring transaction types that don't lock in an exit price (e.g., spin-offs, demergers).
• Share Repurchases: Share repurchases are a "flexible way to pay out cash amounts that vary from year to year." However, they are "value neutral" and "could even indirectly destroy value if they come at the expense of attractive investments." They are not considered the same long-term commitment as regular dividends by investors.

V. Addressing Uncertainty and Flexibility

• Analyzing Results and Validation: After building a valuation model, it's essential to "test its validity," checking for "mechanical errors or flaws in economic logic" and ensuring that key ratios are consistent with industry economics. "If your estimate is far from the market value, do not jump to the conclusion that the market price is wrong. If a difference exists, search for the cause."
• Sensitivity Analysis: This involves assessing how changes in key variables (financial or operational) affect the final valuation.
• Scenario Creation: Since the future is uncertain, creating scenarios reflecting different macroeconomic, industry, or business developments is crucial. Scenarios should "capture the future states of the world that would have the most impact on value creation over time and a reasonable chance of occurrence." Assigning probabilities to scenarios is part of the process.
• Flexibility: The source introduces the concept of valuing "Flexibility," suggesting a "Hierarchy of Approaches" and "Methods for Valuing Flexibility," including "Real-Option Valuation and Decision Tree Analysis." Flexibility is valuable when there is uncertainty and opportunities to adapt.

VI. Specific Valuation Considerations

• Valuing Nonoperating Assets: The process of moving from Enterprise Value to Value per Share involves "Valuing Nonoperating Assets," "Valuing Interest-Bearing Debt," "Valuing Debt Equivalents," and "Valuing Hybrid Securities and Noncontrolling Interests." Examples of nonoperating assets include excess cash and nonconsolidated subsidiaries.
• Debt Equivalents: These have debt characteristics but are not formal contracts (e.g., operating leases, unfunded pension liabilities, operating provisions like plant decommissioning costs).
• Financial Subsidiaries: Companies with financing subsidiaries that resemble banks require separate valuation due to their distinct economics. Failure to separate them will "distort return on invested capital, free cash flow, and ultimately your perspective on the company’s valuation."
• Emerging Market Valuation: Valuing companies in emerging markets presents challenges related to country risk and capital outflow restrictions. A recommended approach for the risk-free rate starts with the ten-year U.S. government bond yield and adds the projected inflation differential. Beta estimation should use a well-diversified or global market index rather than potentially distorted local indexes. Taxes on repatriated profits need to be included in the DCF.

VII. Common Pitfalls and Misconceptions

• Earnings Per Share (EPS) Dilution: The source highlights the misconception that a deal's short-term impact on EPS is important to value. "Apparently, everyone knows that a transaction’s short-term impact on EPS doesn’t matter. Yet they all pay attention to it." EPS dilution is listed as a dimension that does not indicate value creation or destruction in acquisitions.
• Stock Splits: Stock splits "can’t create value, because the size of the pie available to shareholders does not change." While some claim they make stock more attractive to certain investors, the fundamental value is unaltered.
• Expectations Treadmill: High expectations built into a share price can push companies to take "misguided actions, such as pushing for unrealistic earnings growth or pursuing big, risky acquisitions," potentially leading to value destruction (illustrated by the Mirant example). "a good company and a good investment may not be the same" if future great performance is already priced in.
• Using Broad Peer Groups for Multiples: Relying on broad industry classifications (like SIC or GICS codes) for comparable companies can lead to erroneous conclusions because companies within these codes may have very different economics. It is better to use a "smaller number of peers of companies that truly compete in the same markets with similar products and services."
• Ignoring Underlying Economics in Operating Metrics Multiples: As noted earlier, simply using operating metrics multiples without understanding the underlying business model differences is not insightful.

VIII. Importance of Long-Term Health and Intrinsic Value

• Market Value vs. Intrinsic Value: While market valuation levels align with intrinsic value potential "in the long term," they can "deviate in the short term." Market values reflect "long-term health, not just short-term profits."
• Maintaining Long-Term Health: Focusing solely on short-term performance metrics can be detrimental to a company's "long-term health" (as illustrated by the pharmaceutical and retail examples).
• Performance Targets: Setting performance targets should be "challenging and realistic" and ideally involve a range (base and stretch targets) to communicate aspirations without over-committing. Pitfalls include setting targets that encourage detrimental short-term behavior or are not aligned with long-term value creation.

This briefing document summarizes the key concepts and important takeaways from the provided excerpts, offering a structured overview of valuation principles, methodologies, and practical considerations as presented by McKinsey.

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