Page Connecting Strategy, Business Management & Shareholder Value June 2015 [email protected]...

Page

Connecting Strategy, Business Management & Shareholder Value

June 2015

www.financetalking.com [email protected] +44 (0)1572 717000

Tutor: David Yates

Page

Program

Introduction

Corporate Finance Essentials

Levers for Value Creation

Putting It All Together

2

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Question…

“Our long-term mission and objectives remain firmly in place — to continue to invest in building world-class franchises with sustainable strategic characteristics that create exceptional shareholder value”Stanley Black & Decker Inc 2014 Annual Report

3

What does shareholder value actually mean and how do companies create it?

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Assets

Debt

Equity

Funding Characteristics4

• Must be repaid

• Interest (tax-deductible)

• Covenants

• Debt leverages returns to shareholders

• Less expensive – lower risk, lower return

• Approx 5% interest after tax

• Permanent capital

• Dividend yield + capital growth = TSR

• Voting

• More expensive – high risk, high return

• Approx 10% expected return

PageShareholder Value – Investors’ Perspective

Share Price110 (+10%)

Total Shareholder ReturnTSR = 12%

Dividend 2 (2%)

Share Price100

Beginning of the year

End of the year

TSR should be enough to compensate shareholders for

the risk (opportunity cost)

“Shareholder value is an outcome - not a strategy”, Jack Welch 2009

5

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Shareholders’ Perspective on Profit

TSR

Share Price appreciatio

n

Dividends

Dividends

Retained earnings are reinvested to generate growth

Dividends give shareholders a

cash return

Profit (Net

Income)

Share PriceAppreciation

Dividends Profit(Net Income)

Retained forreinvestment

Dividends

6

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Program

Introduction




7

Page

Which Company is Doing Best?

A B

Profit 10m Profit 10m

8

Page

Which Company is Doing Best?

A B


Assets100m

Debt50m

Equity50m

Assets200m

Debt100m

Equity100m

9

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Is the Business Worth the Effort?10

A B


Assets100m

Debt50m

Equity50m

Assets200m

Debt100m

Equity100m

Return on capital is 10%If cost of capital is 7.5%

A worthwhile business!

Return on capital is 5%If cost of capital is 7.5%

Not worth the effort!

PageShareholder Value – Company Perspective

Profit 10m

Assets100m

Debt50m

Equity50m

Return on capital 15%

2.5mCost of capital 7.5m

Economic Profit


Cost of capital 7.5%

Creating 2.5m of value

11

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Cost of Capital

Profit 10m

Assets100m

Debt50m

Equity50m


Cost of capital:

A core concept in business decision-making– all investments must return more than cost of capital to be economically viable

i.e. ROCE must beat WACC

2.5mCost of capital 7.5m

Economic Profit


Cost of capital 7.5%

12

Creating 2.5m of value

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Assets(Value of

the Enterpris

e)

Debt

Equity (Market Value)

Cost of Capital - Calculations13

Cost of Debt

• 4-5% risk free rate

• Plus extra required by lender for company risk (1-2%?)

• Less tax relief

• Approx 4-6%

Cost of Equity

• 4-5% risk free rate

• Plus extra required for equity risk (3-9%)

• Equity risk premium is higher for some than for others (multiply by β)

• Approx 7-14%

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Weighted Average Cost of Capital?

Assets

Debt@ 5%

Equity@ 10%

Assets

Debt@ 5%

Equity@ 10%

Assets

Debt@ 5%

Equity@ 10%

Note: Assets, Debt and Equity are all at market values

14

Page


Weighted Average Cost of Capital

WACC is (25% x 5) + (75% x 10)

= 8.75%

WACC is (75% x 5) + (25% x 10)

= 6.25%

WACC is (50% x 5) + (50% x 10)

= 7.5%

15

Assets

Debt@ 5%

Equity@ 10%

Assets

Debt@ 5%

Equity@ 10%

Assets

Debt@ 5%

Equity@ 10%

Page

Assets

Debt@ 5%

Equity@ 10%

Assets

Debt@ 5%

Equity@ 10%

Assets

Debt@ 5%

Equity@ 10%

Which is the Riskiest for Investors?

WACC is (75% x 5) + (25% x 10)

= 6.25%

WACC is (50% x 5) + (50% x 10)

= 7.5%

WACC is (25% x 5) + (75% x 10)

= 8.75%


16

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Which is Most Efficient for Investors?


17

Assets

Debt@ 5%

Equity@ 10%

Assets

Debt@ 5%

Equity@ 10%

Assets

Debt@ 5%

Equity@ 10%

WACC is (75% x 5) + (25% x 10)

= 6.25%

WACC is (50% x 5) + (50% x 10)

= 7.5%

WACC is (25% x 5) + (75% x 10)

= 8.75%

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Efficient Balance Sheets


Less efficient

More efficient

Stronger, less risky

Weaker, more risky

18

Assets

Debt@ 5%

Equity@ 10%

Assets

Debt@ 5%

Equity@ 10%

Assets

Debt@ 5%

Equity@ 10%

WACC is (75% x 5) + (25% x 10)

= 6.25%

WACC is (50% x 5) + (50% x 10)

= 7.5%

WACC is (25% x 5) + (75% x 10)

= 8.75%

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How could a company lower its cost of capital?

19

Share buy-backs

Higher leverage

Excellent communication around risk

Reduce stock price volatility

Question…

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The Optimum Capital Structure?C

ost

of

capit

al

Amount of capital

5% -

10% -

Optimum capital structure?

cost

of debt

cost of e

quity

WACC

20

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Changing the Capital Structure

Assets Debt@ 5%

Equity@ 10%

Assets

Equity@ 10%

Debt@ 5%

•Invest using debt•Pay more dividends•Buy back shares

Less efficient

More efficient

Stronger, less risky

Weaker, more risky

•Issue shares for new investment•Issue shares to reduce debt•Make profits and retain them

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Page

Value Creation – Telling the Story

Profit 10m

Assets100m

Debt50m

Equity50m 2.5m

Cost of capital 7.5m

Economic Profit

Allocate capital efficiently

Grow profits

Manage capital

Reduce cost of capital

Manage capital

22

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Driving Growth at the Required Return

ProfitCapital

Growth + Return on capital > cost of capital

Volume Price Costs

Revenue MarginsCapital

allocationCapital

management

Working capital

CapexShare

buy-backsDividends

Leverage(gearing)

23

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The Link with TSR

ProfitCapital


Volume Price Costs


allocationCapital

management

Working capital

CapexShare

buy-backsDividends

Leverage(gearing)

24

TOTAL SHAREHOLDER RETURN= Share price growth + dividends

ST

RA

TE

GY

OU

TC

OM

E

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The Whole Story…


More valuable

+Deliver on

expectations

=Higher share

price?

=

25

Investor RelationsKey drivers:

• Quality• Growth• Risk

Page

Which of the following describes the creation of shareholder value?

Market capitalization exceeds book value

Dividends are higher than the peer group

Return on capital is higher than cost of capital

TSR exceeds the interest rate on bonds

Question…26

Page

Program

Introduction




27

Page

• Today’s value of all the future cash the business is expected to generate

• Very sensitive to assumptions

• Need to use multiples as a sense-check

• Key drivers are quality, growth and risk

• Using ratios to compare similar companies

• Very simple

• Problematic for companies that don’t fit neatly into their sector and for loss-making companies

• Key drivers are quality, growth and risk

Valuation Methodologies Summary

Influences

• Sentiment

• Fundamentals

• Liquidity

Absolute Valuation Discounted Cash Flow Valuation (DCF)

28

Relative Valuation

Influences

• Sentiment

• Fundamentals

• Liquidity

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Forecast thevalue driver

Identify the sector

& sector forward multiple

Apply multiple

Valuing a Company Using Multiples29

Choose appropriate value driver (e.g. net

income, net asset value)

Choose a suitable peer group

Discount or premium according to quality,

growth and risk

Know how you stack up against your peers

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Valuing Walmart

Forecast thevalue driver

Identify the sector

& sector forward multiple

Apply multiple

Walmart’s forecast EBITDA is $38.7bn

Company is typical of its sector

Sector EV/EBITDAis 7.6x

Company is worth 7.6 x $38.7bn

= $294.1bn (EV)

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What Might Change the Multiple?31

Forecast the value driver

Identify the sector and

sector multipleApply multiple

• Higher/lower forecast (i.e. earnings upgrade/downgrade)

• More/less certainty on forecast (i.e. QUALITY & RISK)

Better/worse GROWTH prospects than peers

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Using IR to Influence Multiples

Forecast the value driver

Identify the sector and

sector multipleApply multiple

Clear explanation of what drives value

(linking to KPIs and management

compensation)

Articulate how your company’s growth rate

and/or returns differ from peers

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Valuing a Company Using DCF

Forecast cash flows for next

few years

Forecast long term growth rate

Discount all cash flows and add up

Ideally forecast 5-10 years

Assume close to rate of growth in economy

Divide by number of shares to find price

33

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Discounted Cash Flow Valuation

Yr1 Yr2 Yr3 Yr4 Yr5

Forecast period cash flowsContinuing period

cash flows

Yr5 + growth…..

x

x

xx

x

x

x

xx = Present value

Discount rate

34

Page

Approximately what % of a valuation (using a 5-year forecast period) would you expect the terminal value to comprise?

Less than 30%

30-50%

50-70%

Over 70%

35

Question…

PageWalmart DCF Model (WACC 7.9%, LTGR 2%)

17,66217,012 18,337 20,158…

forecast period cash flows $m continuing period cash flows

15,767

Enterprise Value (present value)

15,171

14,597

233,608

20,1580.079 – 0.02

= 341,661

341,661 1.0795

19,0371.0794

17,6621.0792

17,012 1.079

Now

306,699Deduct debt of $41,246m = equity value of $265,453m = $82.44 per share

18,3371.0793

19,037

14,044

19,763 1.0795

19,763

13,512

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PageInfluencing Discounted Cash Flow Valuation

Yr1 Yr2 Yr3 Yr4 Yr5

Forecast period cash flowsContinuing period

cash flows

Yr5 + growth…..

x

x

xx

x

x

x

xx = Present value

Discount rate

• Effective communication of RISK is key

• Lower volatility will reduce cost of capital

• Predictability demonstrates QUALITY of earnings (guidance and targets)

• Profits convert to cash• Returns > cost of capital

• A convincing GROWTH story

Discount rate

37

Page

The Role of Guidance38

Sell-side analysts

Strategic PlanBudget

1 year financial plan

Forecast

Actual Results

Guidance(IR)

Capex plan

• Aim to bring market closer to management’s view of the business

• Use a range rather than a precise number

• Set out economic assumptions

• Give sensitivity to exchange rates, commodity prices, interest rates etc

• Consider using medium-term KPI targets

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OPFCF growth rate in perpetuity

1.0% 1.5% 2.0% 2.5% 3.0%

W 6.9% 85.78 93.15 102.04 112.94 126.63

A 7.4% 77.98 84.09 91.33 100.05 110.75

C 7.9% 71.32 76.44 82.44 89.55 98.10

C 8.4% 65.55 69.91 74.94 80.83 87.80

8.9% 60.52 64.25 68.53 73.47 79.25

Walmart Sensitivity Analysis

Lower WACC and higher growth substantially

increases value

Higher WACC and lower growth substantially

reduces value

Understand the assumptions that are built into your stock

price

39

PageC

heckin

g A

ssum

ptio

ns in

Sto

ck Price

Input data in blue boxes ONLY$ Currency

2016E 2017E 2018E 2019E 2020E$m $m $m $m $m

Revenue 491,722 511,391 531,846 553,120 575,245Growth 4.0% 4.0% 4.0% 4.0%Margin 6.0% 6.0% 6.0% 6.0% 6.0%

EBIT 29,503 30,683 31,911 33,187 34,515Depreciation & amortization 9,200 9,660 10,143 10,650 11,183EBITDA 38,703 40,343 42,054 43,837 45,697Changes in working capital 0 0 0 0 0Capex (12,250) (12,863) (13,506) (14,181) (14,890)Tax 32% (9,441) (9,819) (10,211) (10,620) (11,045)

Operating Free Cash Flow 17,012 17,662 18,337 19,037 19,763

WACC Calculation % Funding SensitivityMarket capitalization 261,303 86%Net debt 41,246 14%Total 302,549

Cost of equity = 8.5%Cost of debt (post tax) = 4.0%WACC = 7.9% 0.5%

Risk free rate 4%Equity risk premium 5%Beta 0.9Growth in OP FCF 2% 0.5%

Number of shares (m) 3,220Share price 81.15

Valuation $82.44

Email [email protected] if

you would like a copy of our simple model

40

mailto:[email protected]

mailto:[email protected]

Page

Program

Introduction




41

Page

Strategic Plan

The Link to Financial Planning & Reporting

The Street

Budget 1 year financial

plan

Forecast

Actual Results

EarningsReleases

42

Capex plan

Guidance(IR)

Page

Strategic Plan

Investment Appraisal

The Street


plan

Forecast

Actual Results

43

Capex plan

Investment appraisal process must ensure growth

without compromising returns

EarningsReleases

Guidance(IR)• Communicate your

capital allocation process

• Justify investment (including acquisitions and R&D) on the basis of returns

Page

Guidance(IR)

Strategic Plan

Budgeting & Forecasting

The Street


plan

Forecast

Actual Results

44

Capex plan

EarningsReleases

• Accurate budgeting/forecasting process is absolutely crucial to successful expectations management

• Consider pre-warning on earnings misses

• Missing guidance destroys trust and is VERY negative for the stock price

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Investors value cash flows. Which of the following actions would increase a company’s cash flows?

Reducing working capital

Increasing capex

Making more profit

Reducing depreciation

45

Question…

Page

ProfitCapital


Volume Price Costs


allocationCapital

management

Working capital

CapexShare

buy-backsDividends

Leverage(gearing)

How do Cash Flows Fit In?

Balance Sheet Income Statement

46

• Communicate around cash conversion

• Capex and working capital are important elements in calculating operating free cash flow

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Telling the Story

ProfitCapital


Volume Price Costs


allocationCapital

management

Working capital

CapexShare

buy-backsDividends

Leverage(gearing)

Capital allocation policy

Efficient cost management

Capex & acquisition returns must meet or beat WACC

Margin development

Appropriate leverage now and

in future?

Efficient working capital management

ROCE/ROIC/ROE target?

Operational leverage

Growth targetsNew products/markets

Leverage cost base

Dividend/buy-back policy

Dividend/buy-back policy

Capex & acquisition returns must meet or beat WACC

Efficient capital structure

47

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Explain How You Create Value48

Walmart 2015 10-K

PageShow How Your Performance Metrics Stack Up

49

“Over the past several years, we have maintained a consistent strategic framework comprised of three key initiatives – Customer Service; Product Authority; and Disciplined Capital Allocation, Productivity and Efficiency”

The Home Depot 2014 10-K

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Explain Your Capital Policy & Allocation50

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Explain the Link with Compensation51

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Connecting Strategy, Business Management & Shareholder Value

June 2015

www.financetalking.com [email protected] +44 (0)1572 717000

Tutor: David Yates

Page Connecting Strategy, Business Management & Shareholder Value June 2015 [email protected]...

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