Value Enhancement: Back to Basics

Aswath Damodaran 1
 Price Enhancement versus Value
Enhancement

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 The Paths to Value Creation

 Using the DCF framework, there are four basic ways in which the value of a firm can be
enhanced:
• The cash flows from existing assets to the firm can be increased, by either
– increasing after-tax earnings from assets in place or
– reducing reinvestment needs (net capital expenditures or working capital)
• The expected growth rate in these cash flows can be increased by either
– Increasing the rate of reinvestment in the firm
– Improving the return on capital on those reinvestments
• The length of the high growth period can be extended to allow for more years of high growth.
• The cost of capital can be reduced by
– Reducing the operating risk in investments/assets
– Changing the financial mix
– Changing the financing composition

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 Value Creation 1: Increase Cash Flows from
Assets in Place

More efficient
operations and Revenues
cost cuttting:
Higher Margins * Operating Margin

= EBIT
Divest assets that
have negative EBIT - Tax Rate * EBIT

= EBIT (1-t) Live off past over-

Reduce tax rate investment
- moving income to lower tax locales + Depreciation
- transfer pricing - Capital Expenditures
- risk management - Chg in Working Capital Better inventory
= FCFF management and
tighter credit policies

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 Value Creation 2: Increase Expected Growth

Reinvest more in Do acquisitions

projects Reinvestment Rate

Increase operating * Return on Capital Increase capital turnover ratio

margins
= Expected Growth Rate

Price Leader versus Volume Leader Strategies

Return on Capital = Operating Margin * Capital Turnover Ratio

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 III. Building Competitive Advantages: Increase
length of the growth period

Increase length of growth period

Build on existing Find new

competitive competitive
advantages advantages

Brand Legal Switching Cost

name Protection Costs advantages

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 Value Creation 4: Reduce Cost of Capital

Outsourcing Flexible wage contracts &

cost structure

Reduce operating Change financing mix

leverage

Cost of Equity (E/(D+E) + Pre-tax Cost of Debt (D./(D+E)) = Cost of Capital

Make product or service Match debt to

less discretionary to assets, reducing
customers default risk

Changing More Swaps Derivatives Hybrids

product effective
characteristics advertising

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 Telecom Italia: A Valuation (in Euros)
Reinvestment Rate Return on Capital
82.06% Expected Growth 9.96%
Cashflow to Firm in EBIT (1-t)
EBIT(1-t) : 2196 .8206*.0996 = .0817
- Nt CpX 1549 Stable Growth
8.17 %
- Chg WC 253 g = 4%; Beta = 0.87
= FCFF 394 Country risk prem = 0%
Reinvest 40.2% of EBIT(1-t): 4%/9.96%
WC : 13% of
Revenues Terminal Value 5= 2024/(.0686-.04) = 70,898
50.457
- 9809= 40.647 465 503 544 589 637
Per Share: 7.73 E
Forever
Discount at Cost of Capital (WACC) = 9.05% (0.8416) + 2.26% (0.1584) = 7.98%

Cost of Equity Cost of Debt

9.05% (4.24%+ 0.20%)(1-.4908) Weights
= 2.26% E = 84.16% D = 15.84%

Riskfree Rate :
Government Bond Risk Premium
Rate = 4.24% Beta 4.0% + 1.53%
+ 0.87 X

Unlevered Beta for Firm’s D/E Mature Mkt Country Risk

Sector: 0.79 Ratio: 18.8% Premium Premium
4% 1.53%

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 Telecom Italia: Restructured(in Euros)
Reinvestment Rate Return on Capital
82.06% Expected Growth 11.96 %
Cashflow to Firm in EBIT (1-t)
EBIT(1-t) : 2196 .8206*.1196 = .0981
- Nt CpX 1549 Stable Growth
9.81 %
- Chg WC 253 g = 4%; Beta = 1.06
= FCFF 394 Country risk prem = 0%
Reinvest 33.4% of EBIT(1-t): 4%/11.96%
WC : 6.75% of
Revenues Terminal Value 5= 2428/(.0646-.04) = 98,649
71,671- 9809=
61,862 564 620 680 747 820
Per Share: 11.77 E
Forever
Discount at Cost of Capital (WACC) = 10.1% (0.60) + 3.43% (0.40) = 7.43%

Cost of Equity Cost of Debt

10.1% (4.24%+ 2.50%)(1-.4908) Weights
= 3.43% E = 60% D = 40%

Riskfree Rate :
Government Bond Risk Premium
Rate = 4.24% Beta 4.0% + 1.53%
+ 1.06 X

Unlevered Beta for Firm’s D/E Mature Mkt Country Risk

Sector: 0.79 Ratio: 66.7 % Premium Premium
4% 1.53%

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 Compaq: Status Quo
Return on Capital
Current Cashflow to Firm Reinvestment Rate 11.62% (1998)
EBIT(1-t) : 1,395 93.28% Expected Growth
- Nt CpX 1,012 in EBIT (1-t) Stable Growth
- Chg WC 290 .9328*.1162= .1084 g = 5%; Beta = 1.00;
= FCFF 94 $2,451 ROC=11.62%
10.84 %
Reinvestment Rate =93.28% $ 1054 Reinvestment Rate=43.03%
$1,397

Terminal Value 5= 1397/(.10-.05) = 27934

Asset Value: 16923

+ Cash: 4091 EBIT(1-t)$1,546.62 $1,714.30 $1,900.17 $2,106.18 $2,334.53
- Debt: 0 - Reinv $1,442.78 $1,599.20 $1,772.59 $1,964.77 $2,177.78
=Equity 21,014 FCFF $103.84 $115.10 $127.58 $141.41 $156.75
-Options 538
Value/Share $12.11
Discount at Cost of Capital (WACC) = 11.16% (1.00) + 4.55% (0.00) = 11.16%

Cost of Equity Cost of Debt

11.16% (6%+ 1.00%)(1-.35) Weights
= 4.55% E = 100% D = 0%

Riskfree Rate :
Government Bond Risk Premium
Rate = 6% Beta 4%
+ 1.29 X

Unlevered Beta for Firm’s D/E Historical US Country Risk

Sectors: 1.29 Ratio: 0% Premium Premium
4% 0%

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 Compaq: Restructured
Return on Capital
Current Cashflow to Firm Reinvestment Rate 19.76%
EBIT(1-t) : 1,395 93.28% (1998) Expected Growth
- Nt CpX 1012 in EBIT (1-t) Stable Growth
- Chg WC 290 .9328*1976-= .1843 g = 5%; Beta = 1.00;
= FCFF 94 18.43% ROC=19.76%
Reinvestment Rate =93.28% Reinvestment Rate= 25.30%

Terminal Value 5= 5942/(.0904-.05) = 147,070

Firm Value: 54895

EBIT(1-t) $1,653 $1,957 $2,318 $2,745 $3,251 $3,851 $4,560 $5,401 $6,397 $7,576
+ Cash: 4091
- Reinv $1,542 $1,826 $2,162 $2,561 $3,033 $3,592 $4,254 $5,038 $5,967 $7,067
- Debt: 0 FCFF $111 $131 $156 $184 $218 $259 $306 $363 $429 $509
=Equity 58448
-Options 538
Value/Share $34.56
Discount at Cost of Capital (WACC) = 12.50% (0.80) + 5.20% (0.20) = 10.64%

Cost of Equity Cost of Debt

12.00% (6%+ 2%)(1-.35) Weights
= 5.20% E = 80% D = 20%

Riskfree Rate :
Government Bond Risk Premium
Rate = 6% Beta 4.00%
+ 1.50 X

Unlevered Beta for Firm’s D/E Mature risk Country Risk

Sectors: 1.29 Ratio: 0.00% premium Premium
4% 0.00%

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 Alternative Approaches to Value Enhancement

 Maximize a variable that is correlated with the value of the firm.

There are several choices for such a variable. It could be
• an accounting variable, such as earnings or return on investment
• a marketing variable, such as market share
• a cash flow variable, such as cash flow return on investment (CFROI)
• a risk-adjusted cash flow variable, such as Economic Value Added (EVA)
 The advantages of using these variables are that they
• Are often simpler and easier to use than DCF value.
 The disadvantage is that the
• Simplicity comes at a cost; these variables are not perfectly correlated
with DCF value.

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 Economic Value Added (EVA) and CFROI

 The Economic Value Added (EVA) is a measure of surplus value

created on an investment.
• Define the return on capital (ROC) to be the “true” cash flow return on
capital earned on an investment.
• Define the cost of capital as the weighted average of the costs of the
different financing instruments used to finance the investment.
EVA = (Return on Capital - Cost of Capital) (Capital Invested in Project)
 The CFROI is a measure of the cash flow return made on capital
CFROI = (Adjusted EBIT (1-t) + Depreciation & Other Non-cash
Charges) / Capital Invested

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 A Simple Illustration

 Assume that you have a firm with a book value value of capital of $
100 million, on which it expects to generate a return on capital of
15% in perpetuity with a cost of capital of 10%.
 This firm is expected to make additional investments of $ 10 million
at the beginning of each year for the next 5 years. These investments
are also expected to generate 15% as return on capital in perpetuity,
with a cost of capital of 10%.
 After year 5, assume that
• The earnings will grow 5% a year in perpetuity.
• The firm will keep reinvesting back into the business but the return on
capital on these new investments will be equal to the cost of capital
(10%).

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 Firm Value using EVA Approach

Capital Invested in Assets in Place = $ 100

EVA from Assets in Place = (.15 – .10) (100)/.10 = $ 50
+ PV of EVA from New Investments in Year 1 = [(.15 -– .10)(10)/.10] =$ 5
+ PV of EVA from New Investments in Year 2 = [(.15 -– .10)(10)/.10]/1.1 = $ 4.55
+ PV of EVA from New Investments in Year 3 = [(.15 -– .10)(10)/.10]/1.12 = $ 4.13
+ PV of EVA from New Investments in Year 4 = [(.15 -– .10)(10)/.10]/1.13 = $ 3.76
+ PV of EVA from New Investments in Year 5 = [(.15 -– .10)(10)/.10]/1.14 = $ 3.42
Value of Firm = $ 170.85

Aswath Damodaran 15
 Firm Value using DCF Valuation: Estimating
FCFF

Base 1 2 3 4 5 Term.
Y ear Y ear
EBIT (1-t) : Assets in Place $ 15.00 $ 15.00 $ 15.00 $ 15.00 $ 15.00 $ 15.00
EBIT(1-t) :Investments- Yr 1 $ 1.50 $ 1.50 $ 1.50 $ 1.50 $ 1.50
EBIT(1-t) :Investments- Yr 2 $ 1.50 $ 1.50 $ 1.50 $ 1.50
EBIT(1-t): Investments -Yr 3 $ 1.50 $ 1.50 $ 1.50
EBIT(1-t): Investments -Yr 4 $ 1.50 $ 1.50
EBIT(1-t): Investments- Yr 5 $ 1.50
Total EBIT(1-t) $ 16.50 $ 18.00 $ 19.50 $ 21.00 $ 22.50 $ 23.63
- Net Capital Expenditures $10.00 $ 10.00 $ 10.00 $ 10.00 $ 10.00 $ 11.25 $ 11.81
FCFF $ 6.50 $ 8.00 $ 9.50 $ 11.00 $ 11.25 $ 11.81

After year 5, the reinvestment rate is 50% = g/ ROC

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 Firm Value: Present Value of FCFF

Year 0 1 2 3 4 5 Term Year

FCFF $ 6.50 $ 8.00 $ 9.50 $ 11.00 $ 11.25 $ 11.81
PV of FCFF ($10) $ 5.91 $ 6.61 $ 7.14 $ 7.51 $ 6.99
Terminal Value $ 236.25
PV of Terminal Value $ 146.69

Value of Firm $170.85

Aswath Damodaran 17
 Implications

 Growth, by itself, does not create value. It is growth, with investment

in excess return projects, that creates value.
• The growth of 5% a year after year 5 creates no additional value.
 The “market value added” (MVA), which is defined to be the excess
of market value over capital invested is a function of tthe excess value
created.
• In the example above, the market value of $ 170.85 million exceeds the
book value of $ 100 million, because the return on capital is 5% higher
than the cost of capital.

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 Year-by-year EVA Changes

 Firms are often evaluated based upon year-to-year changes in EVA

rather than the present value of EVA over time.
 The advantage of this comparison is that it is simple and does not
require the making of forecasts about future earnings potential.
 Another advantage is that it can be broken down by any unit - person,
division etc., as long as one is willing to assign capital and allocate
earnings across these same units.
 While it is simpler than DCF valuation, using year-by-year EVA
changes comes at a cost. In particular, it is entirely possible that a firm
which focuses on increasing EVA on a year-to-year basis may end up
being less valuable.

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 1. The Growth Tradeoff

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 2. The Risk Tradeoff

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 3. Delivering a high EVA may not translate into
higher stock prices…

 The relationship between EVA and Market Value Changes is more

complicated than the one between EVA and Firm Value.
 The market value of a firm reflects not only the Expected EVA of
Assets in Place but also the Expected EVA from Future Projects
 To the extent that the actual economic value added is smaller than the
expected EVA the market value can decrease even though the EVA is
higher.

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 High EVA companies do not earn excess
returns

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 Increases in EVA do not create excess returns

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 Implications of Findings

 This does not imply that increasing EVA is bad from a corporate
finance standpoint. In fact, given a choice between delivering a
“below-expectation” EVA and no EVA at all, the firm should deliver
the “below-expectation” EVA.
 It does suggest that the correlation between increasing year-to-year
EVA and market value will be weaker for firms with high anticipated
growth (and excess returns) than for firms with low or no anticipated
growth.
 It does suggest also that “investment strategies”based upon EVA have
to be carefully constructed, especially for firms where there is an
expectation built into prices of “high” surplus returns.

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 When focusing on year-to-year EVA changes
has least side effects

1. Most or all of the assets of the firm are already in place; i.e, very little
or none of the value of the firm is expected to come from future
growth.
• [This minimizes the risk that increases in current EVA come at the
expense of future EVA]
2. The leverage is stable and the cost of capital cannot be altered easily
by the investment decisions made by the firm.
• [This minimizes the risk that the higher EVA is accompanied by an
increase in the cost of capital]
3. The firm is in a sector where investors anticipate little or not surplus
returns; i.e., firms in this sector are expected to earn their cost of
capital.
• [This minimizes the risk that the increase in EVA is less than what the
market expected it to be, leading to a drop in the market price.]

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 When focusing on year-to-year EVA changes
can be dangerous

1. High growth firms, where the bulk of the value can be attributed to
future growth.
2. Firms where neither the leverage not the risk profile of the firm is
stable, and can be changed by actions taken by the firm.
3. Firms where the current market value has imputed in it expectations of
significant surplus value or excess return projects in the future.
Note that all of these problems can be avoided if we restate the objective as
maximizing the present value of EVA over time. If we do so, however,
some of the perceived advantages of EVA - its simplicity and
observability - disappear.

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