Ferdinand petra valuation - roce and value creation (extract)

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Corporate Valuation
ROCE and Value Creation (Extract)
Prof: Ferdinand Petra (contact@ferdinand-petra.com)
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ROCE and Value Creation

Main Financial Aggregates (P&L)
Valuation
Operating Cycle
Investment Cycle
Capital Structure
Other
( + )
EBITDA
EBIT
EBT
Sales
- Operating expenses
- Depreciation & Amortization
+/- Net financial charges
Net income (group share)
+/- Available for sale – Taxes
– Non-controlling interests
( + )
( + )

Capital Employed And Invested Capital
Valuation
Invested
Capital (IC)
Capital Employed
(CE)
CAPITAL EMPLOYED = INVESTED CAPITAL
Fixed
Assets
Shareholders’
Equity
Net
Debt
Working
Capital
100% of all Controlled net operating assets

Operating Working Capital vs. Working Capital
All current
assets
linked to ops
– Cash and
Cash eq
All current
Liabilities
liked to op –
ST fin. debt
Operating
Working Capital
(does not include dividend
payable and tax payable)
= A/R + Inventory +
Prepaid Expense (=
rental and
insurance)
= A/P + Accrued
Expense (= salary
costs)
 Working Capital = Operating Working Capital + Non-operating Working Capital
Valuation

One Step Further: Value & Financial Aggregates
Valuation
Cash & Cash
equivalent
Investments
Associates
Controlled
Net Operating
Assets
Common
Equity
Preferred
Equity
NCI
Financial Debt¹
Interest income
Dividend income
Inc. from
associates
Sales
EBITDA
EBIT
FCFF
Net income
(group share)
Pref dividends
Net income
attributable
to NCI
Interest expense¹
¹ Can include other “debt-like” elements (e.g. under-funded pension)

Return On Capital Employed
 Return On Capital Employed (ROCE)
ROCE =
EBIT (1-tax)
CE
 Breakdown of ROCE
ROCE After-tax return on
Capital Employed
Capital Employed
Effective tax rate
CE
tax
A relatively high ROCE can
be justified by either:
 A high operating margin and
a low capital employed
turnover ratio
(e.g.: heavy industry)
 A low margin but a high
capital employed turnover
ratio
(e.g.: interim work)
→ ROCE is independent from
the capital structure
EBIT (1-tax)
Sales
Sales
CE
After-tax
operating margin
Capital
employed
turnover ratio=
Return on Capital Employed (ROCE)
x
x
Profitability Capital Efficiency
Valuation

Return On Capital Employed – “Devil Is In The Details”
EBIT
Tax Rate
Issues when
comparing
ROCEs
 EBIT has to be
− Recurring (i.e. exclude non-recurring items)
− Continuing (i.e. exclude business you intend to sell)
− Core (i.e. include only income/expense from core operations)
 Effective Tax Rate (ETR) = Tax expense / Profit before tax
− Usually polluted by non-recuring items
 Statutory Tax Rate (STR) = tax rate in the country where the parent
company is located
− Does not work for multi-national firms
 Marginal Tax Rate (MTR) = tax rate at which the extra € of profit is taxed
− Nobody knows how much it is
 Adjusted STR = STR + adjustments for different geographies
− Best proxy I know to a « clean » tax rate
 Capitalization of costs (e.g. R&D)
 Operating vs. financial leases
 Historical goodwill impairments
 Underfunded pension deficit….
Valuation

ROCE Decomposition (FY 2015)
ROCE of 5%
BHP Billiton
Eutelsat
Sanofi
Maroc Télécom
LVMH
LafargeHolcim
Arcelor Mittal
Danone
L'Oréal
Burberry
M6
Unilever
E.ON
Total
Tesco
Fiat
Adecco
Microsoft
Infosys
Intel
Google
Disney
Toyota
Wall Mart
0%
5%
10%
15%
20%
25%
30%
35%
40%
0.0 1.5 3.0 4.5 6.0
Sales / Capital Employed
After-taxEBIT/Sales
Low Asset turnover High Asset turnover
Low
margins
High
Margins
Source : Exane BNP Paribas, annual reports
Hermes
Valuation

Book Profitability And Expected Profitability
Book and expected returns can be very different!
Book Return Expected Return
ROCE
ROE
Roce
Expected return on
capital employed
Ke
Cost of equity
Valuation

Enterprise Value Drivers
 EV = Ve + Vd
 Equity Value (Ve) depends on expected return from shareholders (cost of equity: Ke)
 Net Debt value (Vd) depends on market price of debt (cost of debt: Kd)
Ve
EVRoce
Expected Return on
Capital Employed
Vd Kd
Wacc
Expected
growth
Operating risk
Financial Risk
Ke



Note: abbreviations “Ve”, “EqV”, “Equity Value” have the same meaning
=
Valuation

Weighted Average Cost of Capital (WACC)
 Wacc is the average return expected by both equity and debt investors
 Other capital providers maybe added if material (e.g. preferred shareholders, NCI,
capitalised leases…)
 The calculation of weights is performed at market value
 Wacc reflects the blended risk taken (hence expected return) to invest in the company
 Wacc is directly comparable to ROCE (after tax)
𝑊𝐴𝐶𝐶 = 𝐾𝑒 ∗
𝑉𝑒
𝑉𝑒 + 𝑉𝑑
+ 𝐾 𝑑 ∗ (1 − 𝑇𝑎𝑥)
𝑉𝑑
𝑉𝑒 + 𝑉𝑑
Valuation

Value Creation (1/3)
Or how to achieve an operating return (after tax) > than the cost of capital
i.e. to generate a positive spread between:
 Spread is the difference between the return on capital employed and the weighted
average cost of capital
What the company yields The cost of capital
ROCE
Weighted Average Cost
of Capital (WACC)-
Valuation

 There is value creation if the spread is positive (yet, spread may be negative in the short
run)
 ROCE > WACC  EV > CE
 ROCE close to WACC  EV close to CE
 ROCE < WACC  EV < CE
 Limitation: need to look at trend over time
Valuation

 Spread and growth are key value drivers
 Value creation depends on:
 The level of the expected spread (Roce - Wacc)
 Growth perspectives (g) in the long run
Value
Creation
Spread > 0
Spread < 0
Growth (g)
Valuation

Value Creation & BCG Matrix
“Stars”
“Questions
Marks”
“Cash
Cows”
“Dogs”
Roce - Wacc
Growth in CE
Value destruction
Stable Value
Value creation
Missed opp’s
Valuation

Ferdinand petra valuation - roce and value creation (extract)

Ferdinand petra valuation - roce and value creation (extract)

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