Value-Based Management and Course Summary

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Value-Based Management andCourse Summary

• Week 14 April 20, 2006

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Maximize Shareholders Wealth

• Management seeks financial policies and
  strategies that increase value of shares
• Policies and strategies that produce returns
  larger than investors opportunity costs increase
  value (economic value added)
• Sustained ability of management to add economic
  value increases the value of the firms assets
  relative to investment costs (market value added)

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Market and Economic Value Added
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Positive NPVs, MVA and EVA

• Positive net present value projects earn higher
  than the discount rate
• The discount rate captures the opportunity cost
  of capital being tied up
• The dollar amounts of free cash flow earned above
  the opportunity rate is EVA
• The present value at the discount rate of EVA is
  MVA

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Advisors and Service Providers

• Investment bankers assist management in adding
  value
• Advice
• Implementation
• Venture capitalists create value
• For their investors through excess returns
• For the clients through realization of investment
  plans (LBOs and venture capital)

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Performance Assessment

• For public companies, share price performance is
  the first step in assessing managements
  performance
• To dig into details, must use accounting data
• Dupont analysis
• Analysis of operations and segments
• Objective is to identify realized or potential
  sources of value

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Market Value of the Firm

• Value of the entire firm entity value
• Copland et al and PVFIRM calculate market value
  of the entity market value of D E
• Entity value is present value of all free cash
  flows, available for division among all
  investors, whether in form of debt or equity
• Cash flows to entire firm discounted at weighted
  average cost of capital

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Advantages of Entity Approach

• Focuses on operations and not financing, avoiding
  problem of changing capital structure through
  time
• Focuses on free cash flow and pinpoints impact of
  alternative strategies
• Free cash flow is net operating profit less an
  allowance for taxes (NOPLAT) minus necessary
  investments in working capital and fixed assets
• Can focus on explicit forecast period and
  continuing values after explicit forecast period

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Free Cash Flow

• Free cash flow is standard approach
• Net Operating Profit less Adjustment for Taxes
  (NOPLAT) - Net Investments
• Free cash flow does not include interest expenses
  (or other financing costs)
• Net investments are from working capital and
  capital expenditures
• Need sales, operating costs, cash, accounts
  receivable, accounts payable, and inventory
  assumptions

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Financial Analysis

• Required for assumptions concerning future
  performance
• Require historical and comparable firm data but
  future may not be like the past
• You can use my handout Financial Statement
  Analysis and Assumptions for Valuation
• Always apply plausibility check to both ratios,
  assumptions, and projections
• Ratio analysis of projections useful in assessing
  plausibility of assumptions

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Dupont Analysis of Performance

• Dupont Analysis focuses on return on equity (RWJ,
  p. 39)
• Closest to goal of management
• Ratios can be calculated in different ways
• Year-ending number balance sheet number or
  averages of two years
• Before tax or after tax

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Abbreviations used in Ratios

• Abbreviations for accounting values usedROE
  return on equityEAC earnings available to
  commonBVE book value of equityEBT earnings
  before taxEBIT earnings before tax and
  interestSLS salesASSTS total operating
  assets

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Basic Ratio Approach

• ROE can be decomposed into elements
• Focus first on gross return on assets (p. 38)
• ROA Earning Power determined by gross profit
  margin and asset turnover

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Gross Profit Margin (p. 38)

• Sales
• Components of Costs
• Materials
• Labor
• SGA
• Other
• Common size income statement valuable
• Need assumptions for future on these

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Asset Turnover (p. 35)

• Working Capital
• Inventories
• Accounts Receivable
• Look at liquidity and activity ratios
• Turnover, days
• Current liabilities trade and bank debt
• Fixed Assets
• Net vs. Gross
• Turnover, average age
• Need assumptions to project these

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Valuation is Critical to Finance

• Three critical factors in valuation
• Cash flows
• Discount rates
• Calculation of net present value
• Where does value come from?
• Ability to earn excess returns (EVA)
• Sustained ability to invest at excess returns
  (results in MVA)

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Markets and Firms

• Firms operate in markets
• Goods and services (products and investments)
• Financial markets
• Efficient market theory is benchmark for analysis
  in finance
• No excess returns possible
• Forces close examination on sources of value
• Inefficiencies or inability to arbitrage are
  sources of value

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Financial Theory and Practice

• Well-defined objective function (maximize
  shareholders wealth)
• Theories of how corporate policies and strategies
  influence value
• Investments
• Capital structure
• Dividends
• All require analysis of cash flows, discount
  rate, and present value

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Course Summary Apr. 27, 2006

• Prepare Vyaderm Pharmaceutical case (no write-up
  required) but bring analysis
• Begin review for final examination by looking
  over past cases analyses and reviewing issues
  raised