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

ISBN 0-471-36190-9

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This alternative calculation generates the same value for economic profit:

Economic profit = S100 - ($1,000 x 8%)

This approach shows that economic profit is similar in concept to accounting net income, but it explicitly charges a company for all its capital, not just the interest on its debt.

A simple example will illustrate how economic profit can be used for valuations. Assume that Company C from above invested $1,000 in working capital and fixed assets at the beginning of period 1. Each year after that it earns $100 of NOPLAT (a 10 percent ROIC). Its net investment is zero, so its free cash flow is also $100. Company C's economic profit is $20 a year as calculated above.

The economic profit approach says that the value of a company equals the amount of capital invested plus a premium or discount equal to the present value of its projected economic profit:

Value = Invested capital + Present value of projected economic profil

The logic behind this is straightforward. If a company earned exactly its WACC every period, then the discounted value of its projected free cash flow should exactly equal its invested capital. The company is worth exactly what was originally invested. A company is worth more or less than its invested capital only to the extent that it earns more or less than its WACC. Therefore, the premium or discount relative to invested capital must equal the present value of the company's future economic profit.

Company C earns $20 a year more than investors demand (its economic profit). So the value of company C should equal $1,000 (its invested capital at the time of the valuation) plus the present value of its economic profit. In this case since economic profit remains forever at $20 a year, we can use a perpetuity formula to calculate the present value of its economic profit.

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Present value of economic profit =

Company C's value is $1,250. If you were to discount company C's free cash flow you would also end up with a value for company C of $1,250. Company C's projected free cash flow is $100 a year.

Present value of PO-

SH*

’ 8%

= 51,250

Exhibits 8.11 and 8.12 show the economic profit and economic profit valuation of Hershey Foods. In 1998, Hershey generated economic profit of $293 million. In other words, Hershey made $293 million of operating profit more than required by investors based on the returns available from alternative investments. Note that the economic profit value of Hershey exactly equals the discounted free cash flow value that we calculated earlier in this chapter. Furthermore, as would be expected, the value of operations, $10.2 billion, exceeds the amount of invested capital (at the end of 1998) of $1.8 billion. In present value terms, Hershey has created $8.4 billion of value ($10.2 billion less $1.8 billion).

Exhibit 8.11 Hershey Foods—Economic Profit Calculation

Forecast Forecast Forecast

$ million 1997 1998 1999 2000 2001

Return on invested capital 24.3% 23.0% 23.0% 22.7% 22.6%

WACC 8.3% 7.5^0 7.5% 7.5% 7.5%

Spread 16.0% 15.5% 15.5% 15.2% 15.1%

Invested capital (beginning of year) 1,815 1,885 1,830 1,919 2,005

Economic profit 291 293 283 292 304

NOPLAT 442 434 420 436 454

Capital charge (151) (141) (137) (144) (150)

Economic profit 291 293 283 292 304

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Exhibit 8.12 Hershey Foods—Economic Profit Valuation Summary

/-------------------------------------------------------------------------------------------\

Year Economic Discount factor Present value of

profit (7.5%) economic profit

{S million) ($ million1)

1999 283 0.930 263

2000 292 0.865 252

2001 304 0.805 245

2002 316 0.749 237

2003 329 0.697 li‘3

2004 343 0.648 222

2005 357 0.603 215

2006 372 0.561 209

2007 387 0 522 202

2008 403 0.485 1%

Continuing value 11,858 0.485 5,754

Present value of economic profit 8,024

Invested capital (beginning of year) 1,830

9,854

Mid-year adjustment factor 1.037

Value of operations 10,217

Value of non-operating investments 450

Total enterprise value 10,667

Less: Value of debt 1,282

Equity value 9,385

1 Except per share.

V, J

The Adjusted Present Value (APV) Model

The adjusted present value (APV) model is similar to the enterprise DCF model. As with enterprise DCF, the APV model discounts free cash flows to estimate the value of operations, and ultimately the enterprise value, once non-operating assets are added. From this enterprise value, the value of debt is deducted to arrive at an equity value. The difference is that the APV model separates the value of operations into two components: the value of operations as if the company were entirely equity-financed and the value of the tax benefit arising from debt financing.2

This valuation model reflects the conclusions from the Modigliani-Miller propositions on capital structure developed in the late 1950s and early 1960s. The MM propositions showed that in a world with no taxes, the enterprise value of a company (the sum of its debt plus equity) is independent of capital structure (or the amount of debt relative to equity). The intuitive logic here is that the value of a company should not be affected by how

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