# Valuation Measuring and managing the value ofpanies - Koller T.

ISBN 0-471-36190-9

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Year

Company A 1 2 3 4 5

NOPLAT $ 100.0 $ 105.0 $ 110.3 $ 115.8 $ 121.6

Net investment 25.0 26.2 27.6 39.0 30.4

Free cash flow $ 75.0 $ 78.8 $ 82.7 $ 86.8 $ 91.2

Each year the company's operating profits and free cash flow grow at 5 percent and each year the company reinvests 25 percent of its cash flows in order to achieve future growth at a return of 20 percent. We can say that in this simple world, a company's growth rate is the product of its return on new capital and its investment rate (net investment divided by operating profits):

Growth rate = Return on new invested capital x Investment rate

For Company A,

Growth rate = 20% x 25% = 5%

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Now suppose that Company B wants to generate the same profit growth as company A. It, too, earns $100 in year 1. However, company B earns only a 10 percent return on its capital. For company B to increase its profits in year 2 by $5, it must invest $50 in year 1. Company B's free cash flow would look as follows:

Year

Company A 1 2 Year 3 4 5

NOPLAT $ 100.0 $ 105.0 $ 110.3 $ 115.8 $ 121.6

Net investment 50.0 52.5 55.2 57.9 63.8

Free cash flow $ 50.0 $ 52.5 $ 55.1 $ 57.9 $ 63.8

A greater return on invested capital results in more free cash flow given the same desired growth rate in operating profits. As would be expected, Company A is worth more than Company B despite identical operating profits and growth rates.

Now let's look at how growth drives cash flow and value. Suppose Company A wants to increase its growth rate (and it can invest more capital at the same return). If A wants to grow at 8 percent instead of 5 percent, it must now invest 40 percent of its operating profits each year, as shown next. (We can use the formula developed above to calculate the required investment rate.)

Year

Company A 1 2 3 4 5

NOPLAT $ 100.0 $ 108.0 $ 116.6 $ 126.0 $ 136.0

Net investment 40.0 43.2 46.6 50.4 54.4

Free cash flow $ 60.0 $ 64.8 $ 70.0 $ 75.6 $ 81.6

Note that Company A's free cash flow is lower each year than it had been. At this new higher growth rate, Company A's free cash flow is lower than the first scenario until year 9, but from then on the free cash flow becomes much larger (as shown on Exhibit 8.7). Which scenario results in a higher value? It turns out that as long as the return on new invested capital is greater than the WACC used to discount the cash flow, higher growth will generate greater value. In these two scenarios, if we assume that the growth and return patterns continue forever and that Company A's WACC is 12 percent, then the present value of the 5 percent growth scenario is $1,071 and the present value of the 8 percent growth scenario is $1,500. This means that it is worthwhile for the investors to accept lower free cash flow in the earlier years.

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Exhibit 8.7 Proving a Point on Company A

5% Growth rate ($ millions) Year 1 2 3 4 5 6 7 8 9 10 11 12

NOPLAT 100 105 Net investment 25 26 110 27 116 29 122 31 128 32 134 33 141 35 148 37 155 39 163 41 171 43

Free cash flow 75 79 S3 87 91 96 101 106 111 116 122 128

8% Growth rate ($ millions)

Year 1 2 3 4 5 5 7 8 9 10 11 U

NOPLAT 100 108 117 126 136 147 159 171 185 200 216 233

Net investment 40 43 47 50 54 59 64 68 74 80 86 93

Free cash flow 60 65 70 76 82 88 95 103 111 120 B0 140

Exhibit 8.8 shows a matrix of values for a hypothetical company over a range of projected growth rates and returns on invested capital. A given value can result from different combinations of growth and return. Assuming companies cannot always have more of both, a table like this helps managers set targets for long-term performance improvement. This table also demonstrates what happens when the return on new invested capital does not exceed the cost of capital. If the return exactly equals the WACC, then additional growth neither creates nor destroys value. This makes sense as investors will not pay more for additional growth if they can earn the same returns elsewhere. If the return on new invested capital is less than WACC then additional growth actually destroys value. Investors would be better off investing their capital elsewhere.

These examples are quite simplistic. Companies do not grow at constant rates, they do not invest the same proportion of their profits, and they do not earn the same return on capital every year. However, the core idea that

Exhibit 8.8 How ROIC and Growth Drive Value1

DCF value

Operating profit ROIC

(annual growth) 7.5% 10.0% 12,5% 15,0% 20.0%

3*4 $887 $1,000 $1,058 $1,113 $1,170

6% 708 1,000 1,117 1,295 1,442

9% 410 1,000 1,354 1,591 1,886

A

Value Value Value ?

destruction neutral creation

1 Assumes starting NOPLAT -100, WACC - 10%, and a 25-year horizon after which ROIC - WACC,

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Exhibit 8.9 Hershey Foods—Return on Invested Capital Calculation

f-----------------------------------------------------------------------------------------N

$ million 1997 1998 Forecast 1999 Forecast 2000 Forecast 2001

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