value & valuation: the role of the ceo

Value & ValuationThe Role of the CEO

Michael Herlache MBA

Doctorate of Business Administration in Finance Candidate 2020

CEO of AltQuest Group


IndexI. The Purpose of the Company

II. How Companies Create Value

III. Strategy & Finance

IV. Value & Valuation

V. The Role of the CEO

VI. Value Management

VII. Valuation

VIII. Value Management with Discounted Cash Flows

IX. Growth or Restructuring

X. Value Management Process

XI. Measuring Added Value: ROIC vs. Market Return

XII. Measuring Added Value: Economic Profit & NPV

XIII. Strategies (i.e. Asset Mix) That Maximizes NPV

XIV. Valuation in the Public Markets

XV. Real Markets & Financial Markets

XVI. Value Planning & Control (i.e. Management)

XVII. Value Metrics

XVIII. Value Planning & Control (i.e. Management) in Practice

XIX. Market Value Added

XX. DCF vs. Earnings Multiple

XXI. Cash Flow

XXII. Value Management Capability


XXIII. Value Lifecycle

XXIV. Valuation Frameworks: Discounted Cash Flow

XXV. Modeling Value: Financial Modeling

I. The Purpose of the Company

Companies exist to create value

Business is the art and science of building & monetizing capabilities.


II. How Companies Create Value

Companies create value by investing capital at rates of return that exceed their cost of capital. This is the principle of value creation.

The only thing that differs across companies is the implementation (i.e. different asset and capitalization mix)


III. Strategy & Finance

Rate of Return (IRR) Cost of Capital

Asset Mix Capitalization Mix

Corporate Strategy Finance

Uses Sources


Rate of Return Cost of Capital

Asset Mix Capitalization Mix

Corporate Strategy Finance

Uses Sources

IV. Value & Valuation


Valuation

V. The Role of the CEO


Valuation

Value Management

VI. Value Management


• Valuation to guide business decisions and ultimately corporate policy• Valuation for each strategic alternative; how much value does each create• Managing value mindset throughout organization• Value – Assess it, create it, and communicate it• Review and target performance of asset mix• Communicate the value of the business to shareholders & value of strategy• Value of company derives from ability to generate cash flows

VII. Valuation


Comparable CompaniesComparable TransactionsDiscounted Cash FlowLBO (Financial Sponsor)Accretion/Dilution (Strategic)

VIII. Value Management with Discounted Cash Flows


Discounted Cash Flow

IX. Growth or Restructuring


Continuous CF/EPS performance assessment1. Hit growth target – Then continue growth2. Miss growth target – Then restructure


X. Value Management Process



1. Determine current market valuation of company:1. Market valuation (if public)2. Comp companies3. Comp transactions

2. Compare to DCF as is (is the company being undervalued by the market or overvalued?)

3. Determine sources of deviation from cash flow targets

4. DCF with restructuring

5. DCF with organic growth

6. DCF with inorganic growth

7. DCF with financial engineering (i.e. change in capitalization

8. Summed DCF for total value increase with changes compared to DCF as is

XI. Measuring Value Added: ROIC vs. Market Return



Measure return on invested capital (after-tax operating profits divided by capital invested in working capital, PP&E) and compare it with stock market returns

XII. Measuring Value Added: Economic Profit & NPV



Economic profit = ROIC spread % over cost of capital x invested capital

The objective is to maximize economic profit. When the company is larger, one should use Net Present Value (NPV) which calculates economic profit in a more robust and flexible fashion.

XIII. Valuation in the Public Markets



Valuation in the public markets has investors paying for the performance they expect the company to achieve in the future; investors ultimately end up paying more since their valuations are not based upon the past or cost of the assets.

The CEO should endeavor to have his company in the public markets since the largest multiples are applied in valuation

XIII. Real Markets & Financial Markets



When a public company, the CEO has to both maximize the intrinsic (DCF) value of the company and manage the expectations of the financial market

Differences between actual performance and market expectations and changes in these expectations drive share prices. The delivery of surprises produces higher or lower total shareholder returns

XIII. Value Planning & Control (i.e. Management)



Planning & control system should be put in place to monitor the NPV of every business unit and summed to get the NPV of the corporation. Economic profit (i.e. NPV) targets set annually for next three years, progress monitored monthly and managers’ compensation tied to economic profit against these targets

XIII. Value Metrics



Metrics are to drive decisions and guide all employees toward value creation.

XIII. Value Planning & Control (i.e. Management) in Practice



1. Corporate management sets long-term value creation targets in terms of market value of a company or total returns to shareholders (TRS)

2. Strategic alternatives valued in DCF (i.e. NPV)

3. Intrinsic value of chosen strategic alternative translated into short and medium term financial targets and then targets for operating and strategic value drivers

4. Performance assessed by comparing results with targets on both financial indicators and key value drivers. Managerial rewards linked to performance on financial measures and key value drivers

XIII. Value Metrics: Market Value Added & Total Return to Shareholders



Market Value Added is the difference between the market value of a company’s debt and equity and the amount of capital invested. Measures financial market’s view of future performance relative to capital invested in business.

Total Return to Shareholders measure performance against the expectations of financial markets and changes in these expectations. TRS measures how well a company betas the target set by market expectations

XIII. Value Metrics: DCF vs. Earnings Multiple



DCF is intrinsic value. Earnings multiples are market values.

Earnings alone is inadequate without understanding the investment required to generate the earnings. Should know ROIC

XIII. Cash Flow



Cash flow equals the operating profits of the company less the net investment in working capital and fixed assets to support the company’s growth.

XIII. Value Management Capability



I. Set aspirations and targetsI. An inspirational statement of intentII. Value-linked quantitative target

II. Manage the corporate portfolioI. Strategic theme analysisII. Value management processIII. Three horizon analysis

III. Orient the organization toward value

IV. Understand value drivers

V. Manage business performanceI. Create business unit strategy to maximize valueII. Set value-linked targetsIII. Review performance

VI. Manage individual performance

XIII. Value Management Capability Continued



I. Set aspirations and targetsI. An inspirational statement of intent

I. State that the goal is to maximize shareholder value

II. Vision is “To create shareholder value by being the world’s premier _____ company from a strategic and financial standpoint”

III. States what businesses we are in and what we aspire to be known for




I. Set aspirations and targetsI. An inspirational statement of intent

II. Value-linked quantitative targetI. Mark the milestones toward their aspiration

with value linked targets

II. Target share price (i.e. double every three, four or five years)

III. Target key value drivers (ex. Financial (EBIT) or operational (ex. Number of customers)

IV. Calibrate proposed targets against historical performance to observe how large a gap needs to be closed




II. Manage the corporate portfolioI. Determine to what extent its current

portfolio of businesses will help meet its aspirations.

II. Determine the strategic advantages of the parent corporation

III. Improvement opportunities continuously

IV. Manage growth pipeline




II. Manage the corporate portfolioI. Strategic theme analysis

I. Which capabilities does the corporation possess?

I. Industry shaperII. Deal makerIII. Scarce asset allocatorIV. Skill replicatorV. Performance managerVI. Talent agencyVII. Growth asset attractor

II. Value management processIII. Three horizon analysis




II. Manage the corporate portfolioI. Strategic theme analysisII. Value management process

I. Do DCF to quantify impact of value creation levers: investor communication, internal improvements, disposals, growth opportunities (organic or inorganic), and financial engineering

III. Three horizon analysisI. Ensure that portfolios always include

businesses in all three stages of developmentI. Horizon 1: core businessesII. Horizon 2: emerging opportunities (have

revenues but no CF)III. Horizon 3: future options (initial activity has

begun)




III. Orient the organization toward valueIII. Having the right organization in place ensures

company’s value creation aspirations and strategy are translated into disciplined execution

IV. Hard areas: III. Structure (who reports to whom), Decision rights,

people (key jobs), and coordination mechanisms (how do things get communicated or done)

V. Soft areas:III. Beliefs (how much potential people believe exists in

market), values (what people think is important, and leadership style

VI. Should be clearly designed performance units and individual accountabilities

VII. Organization to then set targets, measure performance, and reward success



IV. Understand value driversIV. What elements in day to day operations have the most impact on value. These are value driversV. Prioritizing these drivers and thus determining where resources should be placed or removed is keyVI. Value driver is a performance variable that has impact on the results of a business (ex. Production

effectiveness or customer satisfaction)VII. The metrics associated with value drivers are called key performance indicators (KPIs) (ex. Capacity utilization

or customer retention rate)VIII. KPIs used for target setting and performance measurementIX. Value drivers should be directly linked to shareholder value creation and cascade down through the

organizationX. Each business unit should have its own key value drivers and KPIsXI. Managers should monitor these numbers regularly to obtain an overview of business performanceXII. 5 to 10 KPIsXIII. Value driver definition starts with creating value trees linking operating elements of business with value

creation, then prioritizing which drivers have greatest impact on value (use DCF to determine sensitivity of business unit’s value to changes in value drivers), then institutionalizing the value drivers by incorporating them into the targets and scorecards of business performance management



V. Manage business performanceI. Manage each business to attain results consistent with top-down aspirations by

process of setting targets for a performance unit and regularly reviewing progress against them

II. Create business unit strategy to maximize valueIII. Set value-linked targets

I. Translating strategy into specific quantitative goalsII. Agree on a target, corporate center and business unit formalize commitment in a

performance contract. Contract contains milestones and quantitative and qualitative goals that business unit needs to achieve through performance period.

III. Targets should cascade through organization (CEO gets financial indicators, business unit head gets key performance indicators, managers get operational levers)

IV. Review performanceI. Structured calendar of performance reviewsII. Scorecard incorporating value metrics and KPIs from value driver analysisIII. Custom scorecards in each business unit




VI. Manage individual performanceVI. Link managerial rewards to behavior that

creates overall shareholder value

VII. People performance management includes target setting and performance reviews. These targets should link to KPIs.

VIII. CEOs get TRS, MVA; Business unit manager gets Economic profit; Functional manager gets operating profit and ROIC; Mid level/frontline gets operating value drivers

XIII. Value Lifecycle



I. Product development – includes market analysis, product design, invention and testing

II. Market introduction – initial release of the product and usually followed by high levels of advertisement

III. Rapid Growth – sales growth accelerates with increasing sales year over year

IV. Maturity phase – the sales growth rate approach the average growth rate of the economy

V. Decline – demand will slowly decline as newer inventions make it obsolete

XIII. Valuation Process: Discounted Cash Flows



I. Forecast Free Cash FlowI. Recasting financials from accounting statements to financial. This process is also called

“normalizing” the financials. Normalizing strips out non-recurring events and non-cash charges which are not part of normal operations of the company. These changes help you get to Free Cash Flow (FCF)

I. Nonrecurring and non-cash charges usually found in MD&A or financial footnotes (above or below operating income line? abnormal expense (reverse expense) or income (reverse income) and what time period does it impact?)

II. Must tax effect when normalizing earnings (expenses reduced tax expense and gains increased tax expense) = Non-recurring item x (1-tax rate)

III. Want to get to EBITDA = earnings before taxes, depreciation & amortization (operating income + D&A)

IV. D&A is from the Income Statement

II. Note historicals

III. Project financials using assumptions

II. Estimate Cost of CapitalI. Perform WACC analysis

II. Develop target capital structure

III. Estimate cost of equity

III. Estimate Terminal ValeI. Use either cash flow multiple (i.e. EBITDA multiple) or growth rate method (i.e. Gordon Growth

method)

II. Discount it back to present value

IV. Calculate resultsI. Bring all cash flows to present

II. Perform sensitivity analysis

III. Interpret results

XIII. Valuation Process: Discounted Cash Flows Continued



I. Forecast Free Cash FlowI. FCF = EBIT – Taxes – Increase in working

capital – capital expenditures + Depreciation and Amortization

II. DCF projects 5 years of FCF plus a terminal value

I. Terminal value is a perpetuity

II. Gordon growth multiple vs. terminal multiple. Use terminal multiple

III. Terminal multiple = (LTM multiple from comps) x EBITDA

XIII. Valuation Process: Discounted Cash Flows Continued



II. Estimate Cost of CapitalI. Cost of capital (aka discount rate) is an investor’s required rate of returnII. The cost of capital should match the cash flows to be discountedIII. Discount rate in two forms; cost of equity and cost of debt. Combined on

balance sheet so discount rate is weighted average cost of capitalIV. WACC is the required rate of return for the overall enterprise. This is simply

a weighted average of the required rates of return for each of the different sources of capital (equity and debt)

V. Perform WACC analysisI. WACC = [Re x (E/(E+D)] + [(Rd x (D/(E+D)) x (1-T)]

II. Cost of equity calculated using the capital asset pricing model (CAPM)I. Re = Rf + Beta (Rm – Rf)

II. Beta is measure of volatility or systematic risk of a security compared to the market as a whole (ex. S&P 500). Firms use 2 year to 5 year betas

III. Un-levering and relevering beta. First unlever beta and re-lever with the subject company’s capital structure (i.e. debt to equity ratio)

I. Bu = BL / [1 + D/E x (1-T)]

II. BL = Bu x [1 + D/E x (1-T)]

III. Cost of debt calculated by averaging (weighted) the coupon rates of its various pieces of debt and multiplying it by the tax shield (1 – tax rate)

XIII. Valuation Process: Comparable Companies



I. Based on how similar companies trade in the public markets

I. Select comp universe

II. “Spread” compsI. Same time frame (Last twelve months)

II. Normalize numbersI. Back out non-recurring items

III. Treasury stock method to calculate share price

III. Select multiples for implied valuation

IV. Apply multiples to target to get valuation

XIII. Valuation Process: Comparable Transactions



I. Based on how similar transactions occurred. Control premiums of 20-25%

I. Select comp universe

II. “Spread” compsI. Same time frame (Last twelve months)

II. Implied valuation multiples

III. Market premiums

III. Select multiples for implied valuation

IV. Apply multiples to target to get valuation

XIII. Modeling Value: Financial Modeling



I. Spread historical financial statements and adjust historical income statement for onetime, extraordinary and non-recurring items

II. Derive historical ratios, trends and variables

III. Project financial statements

IV. Integrate financial statement projects with revolver

value & valuation: the role of the ceo

Economy & Finance