Download (direct link):
Revenues 4,302 4,063 4,245 4,436 4,636
Operating expenses (3,656) (3,452) (3,598) (3,765) (3,936)
Earnings before interest, taxes, and amortization (EBITA) 646 610 648 671 700
Cash taxes on EBITA !204:' (177) (227) (236) (246)
NOPLAT 442 434 420 436 454
Operating current assets 1,035 1,020 1,074 1,122 1,173
Noninterest-bearing current liabilities (508) (412) (501) (523) (547)
Operating working capital 608 57.1 599 6 Ih
Net property, plant, and equipment 1,648 1,477 1,613 1,686 1,762
Other assets net of other liabilities i230: (255) (267) (279) (292)
Operating invested capital 1,885 1,830 1,919 2,005 2,096
Return on invested capital (beginning of year) 24.3% 23.0% 23.0% 22.7% 22.6%
WACC 8.3% 7.3K 7.5% 7.5% 7.5%
Spread 16.0% 15.5% 15.5% 15.2% 15.1%
the key drivers of value are return on invested capital (relative to WACC) and growth is generally applicable for all companies. Exhibit 8.9 shows the calculation of Hershey's return on invested capital. Exhibit 8.10 shows Hershey's historical and projected performance in terms of growth and return on invested capital. These results are summarized below:
Hershey Foods 1989-93 1994-98 1999-2008
Corporation (percent) (percent) (percent)
ROIC 19.0 21.5 22.7
WACC _97 _87 7.5
Spread 9.3 12.8 15.2
Average annual growth
Revenues 9.4 3.1 4.5
NOPLAT 7.3 12.3 2.7
Invested capital 9.9
Exhibit 8.10 Hershey Foods—ROIC and Growth Trends
Hershey has consistently earned a return on invested capital of about 20 percent, even while interest rates and its WACC have declined. Thus, Hershey's spread has increased to an average of 12.8 percent over the five years from 1994 to 1998. Returns on invested capital in this scenario are projected to remain essentially constant. Revenue growth is projected to be somewhat higher than in recent years and NOPLAT is projected to grow in line with revenues (in other words, margins are expected to remain constant). Managers can use information like this to assess the projection and to set long-term performance targets.
In summary, return on invested capital (relative to WACC) and growth are the fundamental drivers of a company's value. To increase its value, a company must do one or more of the following:
• Increase the level of profits it earns on its existing capital in place (earn a higher return on invested capital on legacy assets).
• Ensure that the return on new capital investment exceeds WACC.
• Increase its growth rate, but only as long as the return on new capital exceeds WACC.
• Reduce its cost of capital.
The Economic Profit Model
The second valuation framework that we will use throughout this book is the economic profit (EP) model. In this model, the value of a company equals the amount of capital invested, plus a premium equal to the present value of the value created each year. The concept of economic profit dates to at least 1890, when the economist Alfred Marshall wrote: ''What remains of his [the owner or manager's] profits after deducting interest on his capital at the current rate may be called his earnings of undertaking or management.”1
Marshall said that the value created by a company during any time period (its economic profit) must take into account not only the expenses recorded in its accounting records but also the opportunity cost of the capital employed in the business.
An advantage of the economic profit model over the DCF model is that economic profit is a useful measure for understanding a company's performance in any single year, while free cash flow is not. For example, you would not track a company's progress by comparing actual and projected free cash flow because free cash flow in any year is determined by discretionary investments in fixed assets and working capital. Management could easily improve free cash flow in a given year at the expense of long-term value creation by simply delaying investments.
Economic profit measures the value created in a company in a single period and is defined as follows:
I!ci>ni>mi-c profit = Invested capital >: (ROIC - WACC)
In other words, economic profit equals the spread between the return on invested capital and the cost of capital times the amount of invested capital. Company C has invested capital of $1,000, return on invested capital of 10 percent, and WACC of 8 percent. Its economic profit for the year is $20:
Economic profit = Si ,000 x (10% - 6%)
1 Alfred Marshall, Principles of Economics, vol. 1 (New York: MacMillan, 1890), p. 142.
Economic profit translates the two value drivers discussed earlier, return on invested capital and growth, into a single dollar figure (growth is ultimately related to the amount of invested capital or the size of the company). Another way to define economic profit is as after-tax operating profits less a charge for the capital used by the company.
Economic profit = NOPLAT - Capital charge