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Ferdinand petra valuation - roce and value creation (extract)

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Ferdinand petra valuation - roce and value creation (extract)

  1. 1. 1www.ferdinand-petra.com – Corporate Valuation – All rights reserved 2018 © www.ferdinand-petra.com Corporate Valuation ROCE and Value Creation (Extract) Prof: Ferdinand Petra (contact@ferdinand-petra.com) Any reproduction, copy of this document is strictly forbidden without prior consent of the author
  2. 2. 2www.ferdinand-petra.com – Corporate Valuation – All rights reserved 2018 © ROCE and Value Creation
  3. 3. 3www.ferdinand-petra.com – Corporate Valuation – All rights reserved 2018 © 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 ( + ) ( + ) ROCE and Value Creation
  4. 4. 4www.ferdinand-petra.com – Corporate Valuation – All rights reserved 2018 © 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 ROCE and Value Creation
  5. 5. 5www.ferdinand-petra.com – Corporate Valuation – All rights reserved 2018 © 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 ROCE and Value Creation Valuation
  6. 6. 6www.ferdinand-petra.com – Corporate Valuation – All rights reserved 2018 © 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) ROCE and Value Creation
  7. 7. 7www.ferdinand-petra.com – Corporate Valuation – All rights reserved 2018 © 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 ROCE and Value Creation Valuation
  8. 8. 8www.ferdinand-petra.com – Corporate Valuation – All rights reserved 2018 © 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…. ROCE and Value Creation Valuation
  9. 9. 9www.ferdinand-petra.com – Corporate Valuation – All rights reserved 2018 © 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 ROCE and Value Creation Valuation
  10. 10. 10www.ferdinand-petra.com – Corporate Valuation – All rights reserved 2018 © 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 ROCE and Value Creation Valuation
  11. 11. 11www.ferdinand-petra.com – Corporate Valuation – All rights reserved 2018 © 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 = ROCE and Value Creation Valuation
  12. 12. 12www.ferdinand-petra.com – Corporate Valuation – All rights reserved 2018 © 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 ROCE and Value Creation Valuation
  13. 13. 13www.ferdinand-petra.com – Corporate Valuation – All rights reserved 2018 © 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)- ROCE and Value Creation Valuation
  14. 14. 14www.ferdinand-petra.com – Corporate Valuation – All rights reserved 2018 ©  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 Value Creation (2/3) ROCE and Value Creation Valuation
  15. 15. 15www.ferdinand-petra.com – Corporate Valuation – All rights reserved 2018 ©  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 (3/3) Value Creation Spread > 0 Spread < 0 Growth (g) ROCE and Value Creation Valuation
  16. 16. 16www.ferdinand-petra.com – Corporate Valuation – All rights reserved 2018 © Value Creation & BCG Matrix “Stars” “Questions Marks” “Cash Cows” “Dogs” Roce - Wacc Growth in CE Value destruction Stable Value Value creation Missed opp’s ROCE and Value Creation Valuation

Notes de l'éditeur

  • Controlled Net Operating Assets = FA + Op WC
    Questions for DTA and DTL !!!
    Preferred shares: fixed claim = fixed div , repaid before common shares

    Consolidated a/c

    J’ai changé la couleur en faisant une autre combinaison de bleus mais dites moi si vous voulez que je laisse le orange
  • Why do we use ROCE? For Manager to run their business – times-series + compare with competitors
    1) Saint Gobain (annual report 2015) used as a criteria (ROCE pre-tax) to compensate manager (definition p. 192 – Year end CE including PP&E + WC + net GW + Other intangibles / Excl deferred tax assets arising from
    non-amortizable brands and land)
    2) Diageo : (p. 54 annual report 2015) EBIT (1-T) / Avg CE
    * EBIT is before exceptional operating item but after associates / JVs
    * Tax rate is before exceptional
    * CE is avg beg/mid/end FYE : SHE + Net financial debt + restructuring costs + GW as of 2014 (when IFRS put in place)

    ROCE also called ROIC / EBIT (1-T) also called NOPAT or NOPLAT or EBIAT

    Which EBIT? It has to be recurring, continuing, core => only include elements linked to operations, exclude:
    * restructuring expenses
    * write-off of intangible
    * Capital gain on asset sale

    Issues w/ Capital Employed (when comparing companies)
    * Internally generated intangibles : e.g. brands not capitalized but expensed in SG&A
    * R&D may not be capitalized => Capitalize R&D = will increase EBIT but as well increase CE
    * Capitalize Operating Leases (in that case EBITDAR)
    * Add underfunded pensions
    * Add back any write-off of goodwill especially in 2008 & 2009
    * Should not include Associates or other financial investments as these assets do not generate returns included in EBIT
    * Technically, should adjust for pension provisions if you have on IC side UPD

    Tax rate = Effective tax rate
  • Why do we use ROCE? For Manager to run their business – times-series + compare with competitors
    1) Saint Gobain (annual report 2015) used as a criteria (ROCE pre-tax) to compensate manager (definition p. 192 – Year end CE including PP&E + WC + net GW + Other intangibles / Excl deferred tax assets arising from
    non-amortizable brands and land)
    2) Diageo : (p. 54 annual report 2015) EBIT (1-T) / Avg CE
    * EBIT is before exceptional operating item but after associates / JVs
    * Tax rate is before exceptional
    * CE is avg beg/mid/end FYE : SHE + Net financial debt + restructuring costs + GW as of 2014 (when IFRS put in place)

    ROCE also called ROIC / EBIT (1-T) also called NOPAT or NOPLAT or EBIAT

    Which EBIT? It has to be recurring, continuing, core => only include elements linked to operations, exclude:
    * restructuring expenses
    * write-off of intangible
    * Capital gain on asset sale

    Issues w/ Capital Employed (when comparing companies)
    * Internally generated intangibles : e.g. brands not capitalized but expensed in SG&A
    * R&D may not be capitalized => Capitalize R&D = will increase EBIT but as well increase CE
    * Capitalize Operating Leases (in that case EBITDAR)
    * Add underfunded pensions
    * Add back any write-off of goodwill especially in 2008 & 2009
    * Should not include Associates or other financial investments as these assets do not generate returns included in EBIT
    * Technically, should adjust for pension provisions if you have on IC side UPD

    Tax rate = Effective tax rate
  • Looking at ROCE, what link to do you make with multiples?
    ROCE pre-tax (at BV) is inverse of EV/EBIT (at MV)
    * ROCE (pre-tax) : what is the return (%) on €1 invested in the past
    * EV/EBIT 17E : how much it is needed to invest now in the company to earn €1 additional of future EBIT

    ROE = Net income group share / SHE group
  • Other name of EV = Aggregate Value (Morgan Stanley), Firm Value, TEV (total entp value)

    * EV has 3 drivers (ONLY operational):
    Future expected growth
    Expected Roce => margin level + capital efficiency [need of investment ]
    Operating Risk

    * EV does not depend on WACC (expected by equity and debtholders) nor on the way the EV is financed

    * Fin. Risk  = Kd  and Ke  BUT Debt/Equity  => WACC stays stable (except extreme case)

    Expected growth INCR =>Value INCR but:
    * Operating risk increase as competition will increase and techno break through => Value DECR (ex. Competition with Uber, Yahoo with Google)
    *  in CE (Capex and WC needed) => ROCE  => EV 

    Operating risk (=> As well driver of unlevered Beta)
    Regulation (e.g. Uber)
    Visibility of CFs (utilities vs tech co)
    Competition strength
    FC vs VC – eg automotive
    Sensitivity to GDP (eg retail vs utilities)
  • Value creation ex post / HISTORICAL BASIS
  • Limitation of the method = limited to one year analysis => need to look at trend over time
    * High short-term ROCE can mean mgt is sacrifying LT growth for ST return

    If ROCE Incr over time = co. manage to reinvest $ at a rate >than wacc
    If ROCE decr over time = co unable to reinvest at rate > Wacc (e.g. high competition, price pressure)

    For early stage “growth” co = ROCE decr as company matures (incr of CE) – only valid if initially ROCE >> Wacc
  • You can create value with
    High spread & low growth (utilities)
    Low spread & high growth

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